TAXATION AND INCOME

DISTRIBUTION
Chapter 14
 Vocabulary
• Statutory Incidence
• Economic Incidence
• Tax Shifting
• Partial Equilibrium Models

14-2
 Tax Incidence: General Remarks
• Only people can bear taxes
– Functional distribution of income
– Size distribution of income
• Both sources and uses of income should be considered
• Incidence depends on how prices are determined
• Incidence depends on the disposition of tax revenues
– Balanced-Budget tax incidence
– Differential tax incidence
– Lump-sum tax
– Absolute tax incidence

14-3
Tax Progressiveness Can Be Measured
in Several Ways
• Average tax rate versus
Tax Liabilities under a hypothetical tax
marginal tax rate system
Income Tax Average Marginal
• Proportional tax system Liability Tax Rate Tax Rate
• Progressive tax system $2,000 -$200 -0.10 0.2
3,000 0 0 0.2
• Regressive tax system 5,000 400 0.08 0.2
10,000 1,400 0.14 0.2
30,000 5,400 0.18 0.2

14-4
 Measuring How Progressive a Tax
System Is

T1
 T0 T1  T0
I1 I0
v1  v2 
T0
I1  I 0 I1  I 0
I0

14-5
 Measuring How Progressive a Tax
System is – A Numerical Example
T1  T0
T1
I1  T0
I0 T0
v1  v2 
I1  I 0 I1  I 0
I0
300  200
 300 200
.00025  1000 800
2.0  200
1000  800 1000  800
800

360  240
 360 240
.0003  1000 800
2.0  240
1000  800 1000  800
800
14-6
 Partial Equilibrium Models
• Models that study only one market and ignore
possible spillover effects on other markets
• Economic incidence depends on:
– Elasticities of Supply and Demand
– Tax Salience: the extent to which a tax rate is made
prominent to a taxpayer
• Economic incidence does not depend on
whether it is levied on Consumers or Producers.

14-7
 Unit Tax on Commodities
2.60

Price
2.40
S1
2.20

Before After
Tax Tax 2.00
S0
1.80

Consumers $1.20 $1.40

Pay 1.60

1.40

1.20

Suppliers $1.20 $1.00

1.00
Receive
0.80

D0
0.60
0 1 2 3 4 5 D1 6 7
Quantity
8

14-8
 2.6
SX
Price

2.4
Perfectly
2.2 Inelastic
Supply
2
S
1.8

1.6

1.4

1.2

0.8

0.6
DX
0 1 2 3 4 5 DX’ 6 7 8
Quantity

14-9
 2.6
Price

2.4

2.2

2
S
1.8

1.6 Perfectly
Elastic
1.4 Supply
SX
1.2

0.8

0.6 DX
0 1 2 3 4 5 DX’ 6 7
Quantity 8

14-10
 Ad Valorem Taxes
Price per Pound of food

Sf

Pr

P0

Pm

Df
Df ’
Qr Q0 Qm Pounds of food per year
14-11
 Taxes on Factors
Statutory vs. Economic Incidence
• The Payroll Tax
– Tax on labor that finances Social Security
• Tax on Capital in a Global Economy

14-12
 The Payroll Tax
SL
Wage rate per hour

Pr

wg = w0

wn

DL
DL’
L0 = L1 Hours per year
14-13
Commodity Taxation without Competition

• Monopoly
– Despite market power a monopolist is generally
made worse off
• QD does down
• Price paid by consumers goes up
• Price received by the monopolist goes down
• Profits go down
• Oligopoly
– Can result in higher or lower profits

14-14
 Monopoly

$
Economic MXX
Profits

c
P0 a
ATCX
Economic Pn
i f
Profits
dh g b
after unit
tax ATC0

DX

MRX DX’

X1 X0 MRX’ X per year

14-15
 Profits Taxes
• Economic profit
• Perfect competition
• Monopoly
• Measuring economic profit

14-16
 Tax Incidence and Capitalization
• PR = $R0 + $R1/(1 + r) + $R2/(1 + r)2 + … +
$RT/(1 + r)T
• PR' = $(R0 – u0) + $(R1 – u1)/(1 + r) + $(R2 –
u2)/(1 + r)2 + … + $(RT – uT)/(1 + r)
• u0 + u1/(1 + r) + u2/(1 + r)2 + … + uT/(1 + r)T
• Capitalization: A stream of tax liabilities
becomes incorporated into the price of an
asset

14-17
 General Equilibrium Models
• Show how various markets are interrelated
• Consider a 2-commodity, 2-factor economy resulting in the following
9 possible ad valorem taxes
tKF = a tax on capital used in the production of food
tKM = a tax on capital used in the production of manufactures
tLF = a tax on labor used in the production of food
tLM = a tax on labor used in the production of manufactures
tF = a tax on the consumption of food
tM = a tax on consumption of manufactures
tK = a tax on capital in both sectors
tL = a tax on labor in both sectors
t = a general income tax

14-18
 Tax Equivalence Relations
• Partial factor tax: tax levied on an input in only some of its
uses.
– tKF, tLF, tKM, tLM
• Tax Equivalence: any two sets of taxes that generate the
same changes in relative prices.
tKF and tLF are equivalent to tF
and and and
tKM and tLM are equivalent to tM
are are are
equivalent equivalent equivalent
to to to
tK and tL are equivalent to t
Source: McLure [1971].

14-19
 The Harberger Model
• Assumptions
– Technology
• Elasticity of substitution
• Capital intensive
• Labor intensive
– Behavior of factor suppliers
– Market structure
– Total factor supplies
– Consumer preferences
– Tax incidence framework

14-20
 Analysis of Various Taxes
• Commodity tax (tF)
• Income tax (t)
• General tax on labor (tL)
• Partial factor tax (tKM)
– Output effect
– Factor substitution effect

14-21
 Some Qualifications
• Differences in individuals’ tastes
• Immobile factors
• Variable factor supplies

14-22
 An Applied Incidence Study

Average Federal Tax Rates and Share of Federal Taxes

by Income Quintile (2009)
Income Category Average Federal Tax Rate Share of Federal Taxes
Lowest Quintile 1.0% 0.3%
Second Quintile 6.8% 3.8%
Third Quintile 11.1% 9.4%
Fourth Quintile 15.1% 18.3%
Highest Quintile 23.2% 67.9%
All Quintiles 17.4% 100.0%
Top 1% 28.9% 22.3%
Source: Congressional Budget Office (2012a)

14-23
 Chapter 14 Summary
• Who bears the burden of a tax? It depends on price
changes, which, in turn, depend on:
– Time frame
– Disposition of tax revenue
– Market structure
– Elasticities of supply and demand
– Mobility of factors of production
– Tax salience
• Partial equilibrium incidence and general equilibrium
incidence analyses are used to determine burdens of
unit and ad-valorem taxes

14-24