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CHAPTER 19:

The Equity Implications of Taxation: Tax Incidence

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

The Equity Implications of Taxation: Tax Incidence

19.1 The Three Rules of Tax Incidence

19.3 General Equilibrium Tax Incidence

19.4 The Incidence of Taxation in the United States

19.5 Conclusion

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

The Statutory Burden of a Tax Does Not Describe Who Really Bears the Tax • Statutory incidence: The burden of a tax borne by the party that

sends the check to the government.

• Economic incidence: The burden of taxation measured by the change in the resources available to any economic agent as a result of taxation. • Economic incidence includes tax payments paid and any price

changes caused by the tax.

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Sources of Federal Receipts, 1960 and 2016 Figure 19-1

the16

1960 23 of tax receipts fromcorp 6 it fom indio income payroll I

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Rule 1: The Statutory Burden of a Tax Does Not Describe Who Really Bears the Tax 3

A tax is placed on suppliers, which shifts the supply curve upward. The market price is now 30¢ higher than it was before the tax was imposed.

Figure 19-2

O o

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Rule 1: The Statutory Burden of a Tax Does Not Describe Who Really Bears the Tax 2 • The tax burden for consumers is:

consumer burden = Change in equilibrium price + check to IRS

• For producers, the tax burden is:

producer burden = (-) Change in equilibrium price + check to IRS

1.80 1.50 t O 0.30

1.80 1.50 t 0.50

0.20

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Burden of the Tax on Consumers and Producers 1

• Tax wedge: The difference between what consumers pay and what producers receive (net of tax) from a transaction.

• If the consumer burden is:

• and the producer burden is:

• the tax wedge is:

0.30

0.20

0.50

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Rule 2: The Side of the Market on Which the Tax Is Imposed Is Irrelevant to the Distribution of the Tax Burden

The tax burdens are identical regardless of who bears the statutory burden.

Figure 19-3

O O

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Rule 1: The Statutory Burden of a Tax Does Not Describe Who Really Bears the Tax 2 • The tax burden for consumers is:

consumer burden = Change in equilibrium price + check to IRS

• For producers, the tax burden is:

producer burden = (-) Change in equilibrium price + check to IRS

1.30 1.50 t 0.50 0.30

1.30 1.50 10 0.20

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Rule 3: Parties with Inelastic Supply or Demand Bear Taxes; Parties with Elastic Supply or Demand Avoid Them • The economic incidence of taxation does not depend on the

statutory incidence.

• It is ultimately determined by the elasticities of supply and demand, that is, how responsive the quantity supplied or demanded is to price changes.

• If one side of the market is perfectly inelastic, then it bears the full burden of the tax. There is a full shifting of the tax burden to that side of the market.

o Full shifting: When one party in a transaction bears all of the tax burden.

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Perfectly Inelastic Demand

When demand is perfectly inelastic, producers bear none of the tax, and consumers bear all of the tax.

Figure 19-4 Producer's burden 2.00 1.50 0.50 0

Cons's burden 2.00 1.50 to 0.50 O

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Perfectly Elastic Demand

Producers bear all of the tax, and consumers bear none of the tax.

Figure 19-5

rod burden Ic80 1.50 0.50 0 50

Consburlen 1.50 1.50 to

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

General Case

• In general, the less elastic is demand relative to supply, the larger share of the incidence falls on demand.

• Demand for goods is more elastic when there are many substitutes.

• For products with an inelastic demand, the burden of the tax is borne almost entirely by the consumer.

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Supply Elasticities

The same principles hold for supply as for demand elasticities; elastic factors avoid taxes, while inelastic factors bear them.

Figure 19-6

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Tax Incidence Extensions

To recap:

• The statutory burden of a tax does not describe who really bears the tax.

• The side of the market on which the tax is imposed is irrelevant to the distribution of tax burdens.

• Parties with inelastic supply or demand bear taxes; parties with elastic supply or demand avoid them.

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

General Equilibrium Tax Incidence 1

• Partial equilibrium tax incidence: Analysis that considers the impact of a tax on a market in isolation.

• General equilibrium tax incidence: Analysis that considers the effects on related markets of a tax imposed on one market.

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Effects of a Restaurant Tax: A General Equilibrium Example

Figure 19-10

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

General Equilibrium Tax Incidence 2

If the burden of a tax on restaurants is borne by the restaurants, it must be borne by the factors of production used by the restaurants.

Figure 19-11

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Effect of Tax Scope on Tax Incidence

• Tax incidence depends on how broadly the tax is applied. • Taxes that are broader based are harder to avoid than taxes that

are narrower, so the response of producers and consumers to the tax will be smaller and more inelastic.

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Spillovers Between Product Markets

Consider a tax on a restaurant. A higher after-tax price has three effects on other goods as well:

1. Income effect from lower real income.

2. Substitution effect toward goods that are substitutes for restaurants.

3. Complementary effect: Consumers may reduce their consumption of goods or services that are complements to restaurant meals.

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Current Versus Lifetime Income Incidence

• Tax incidence is usually evaluated by current—rather than lifetime—income.

o Current tax incidence: The incidence of a tax in relation to an individual’s current resources.

o Lifetime tax incidence: The incidence of a tax in relation to an individual’s lifetime resources.

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

The Congressional Budget Office/Tax Policy Center Incidence Assumptions

The Congressional Budget Office and Urban Institute’s Tax Policy Center analyze tax incidence in the United States, assuming:

1. Income taxes are borne fully by households that pay them.

2. Payroll taxes are borne fully by workers.

3. Excise taxes are fully shifted to prices and so are borne by individuals in proportion to their consumption of the taxed item.

4. Corporate taxes are borne 20% by workers and 80% by owners of capital.

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Results of CBO/TPC Incidence Analysis: Total Effective Tax Rates, 1979−2017

1979 1985 1990 1995 2000 2006 2011 2014 2017

Total effective tax rate

All households 22.2% 20.9% 21.5% 22.6% 23.0% 20.7% 18.6% 19.2% 20.2%

Bottom quintile 8.0% 9.8% 8.9% 6.3% 6.4% 4.3% 1.1% 3.1% 3.3%

Top quintile 27.5% 24.0% 25.1% 27.8% 28.0% 25.8% 23.8% 25.1% 26.0%

Effective income tax rate

All households 11.0% 10.2% 10.1% 10.2% 11.8% 9.1% 10.1% 9.2% 10.0%

Bottom quintile 0.0% 0.5% −1.0% −4.4% −4.6% −6.6% −6.0% −4.5% −4.9%

Top quintile 15.7% 14.0% 14.4% 15.5% 17.5% 14.1% 15.3% 15.1% 15.8%

Effective payroll tax rate

All households 6.9% 7.9% 8.4% 8.5% 7.9% 7.5% 5.3% 7.0% 6.9%

Bottom quintile 5.3% 6.6% 7.3% 7.6% 8.2% 8.5% 4.8% 6.6% 7.1%

Top quintile 5.4% 6.5% 6.9% 7.2% 6.3% 5.8% 4.1% 5.9% 5.8%

Effective corporate tax rate

All households 3.4% 1.8% 2.2% 2.8% 2.4% 3.4% 2.5% 2.9% 3.1%

Bottom quintile 1.1% 0.6% 0.6% 0.7% 0.5% 0.5% 0.4% 1.0% 1.1%

Top quintile 5.7% 2.8% 3.3% 4.4% 3.7% 5.4% 4.0% 4.0% 4.2%

Effective excise tax rate

All households 1.0% 0.9% 0.9% 1.0% 0.9% 0.7% 0.7% 0.8% 0.7%

Bottom quintile 1.6% 2.2% 2.0% 2.4% 2.3% 1.9% 1.9% 2.1% 1.5%

Top quintile 0.7% 0.7% 0.6% 0.7% 0.5% 0.4% 0.4% 0.4% 0.5%

Table 19-1

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Results of CBO/TPC Incidence Analysis: Top and Bottom Quintiles’ Shares of Income and Tax Liabilities

1979 1985 1990 1995 2000 2006 2012 2013 2014 2017

Top quintile

Share of income

45.5% 48.6% 49.5% 50.2% 54.8% 55.7% 56.2% 54.5% 51.4% 52.6%

Share of tax liabilities

56.4% 55.8% 57.9% 61.9% 66.6% 69.3% 70.0% 68.0% 67.3% 67.6%

Bottom quintile

Share of income

4.8% 4.6% 4.6% 4.0% 3.9% 3.9% 3.6% 3.6% 4.5% 4.0%

Share of tax liabilities

2.1% 2.3% 1.9% 1.3% 1.1% 0.8% 0.3% 0.3% 0.7% 0.6%

Top 1%

Share of income

9.3% 11.5% 12.1% 12.5% 17.8% 18.8% 18.5% 17.8% 17.1% 15.5%

Share of tax liabilities

15.4% 14.8% 16.2% 20.1% 25.5% 28.3% 25.2% 27.0% 29.8% 25.4%

Table 19-1

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Conclusion

• The “fairness” of any tax reform is one of the primary considerations in policy makers’ positions on tax policy.

• Therefore, it is crucial for public finance economists to have a deep understanding of who really bears the burden of taxation so that we can best inform these distributional debates over the fairness of a proposed or existing tax.

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Learn by Doing: Practice Question 2 Suppose a tax is imposed on the purchasers of couches. Assume that demand for couches is perfectly elastic and that the supply is elastic but not perfectly elastic. The couches are produced in a factory using capital equipment and labor. The supply of labor is perfectly elastic and the supply of capital equipment inelastic in the short run. In the short run, partial equilibrium tax incidence analysis suggests that _____ bear the tax; general equilibrium tax incidence analysis suggests that _____ bear the tax.

a) consumers; couch factories

b) consumers; capital owners

c) couch factories; capital owners

d) couch factories; couch factories

CHAPTER 19: The Equity Implications of Taxation: Tax Incidence

Learn by Doing: Practice Question 2 (Answer)

Suppose a tax is imposed on the purchasers of couches. Assume that demand for couches is perfectly elastic and that the supply is elastic, but not perfectly elastic. The couches are produced in a factory using capital equipment and labor. The supply of labor is perfectly elastic and the supply of capital equipment inelastic in the short run. In the short run, partial equilibrium tax incidence analysis suggests that _____ bear the tax; general equilibrium tax incidence analysis suggests that _____ bear the tax.

a) consumers; couch factories

b) consumers; capital owners

c) couch factories; capital owners (correct answer)

d) couch factories; couch factories