PUBLIC ECONOMICS AND FINANCE

TAX INCIDENCE

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TAX POLICY QUESTIONS

• Are some taxes more efficient? (last class: excess burden)

• Who should we levy the tax on? (today: tax incidence)

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TAX INCIDENCE

• Suppose we are a local government and we need to finance a new road repair
program and decide to finance the project with a new gas tax

• Who should we levy the tax on?

• Gas producers (oil companies) or consumers (all drivers)?

• Statutory incidence: burden of the tax in terms of legal responsibility

• i.e., who physically pays the bill 3
TAX BURDEN

• Suppose we choose a tax of $4 per gallon placed on oil companies. How might
the oil company change its behavior in response to the tax?
• Raise the price of gas!
• When defining the burden of the tax, statutory incidence ignores that prices may
change due to the tax

• Economic incidence: burden of the tax measured by change in resources of

each agent as a result of the tax
• Consumer tax burden = [post-tax price - pre-tax price] + tax on consumer
• Producer tax burden = [pre-tax price - post-tax price] + tax on producer
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 EXAMPLE: NO TAXES
Price per
gallon (P)

• Example: Market for gasoline

S
• Demand: PD=30-3QD
• Supply: PS=10+QS

• If no taxes…
P* = $15 A
• Set PD=PS : 30-3Q=10+Q  Q*=5
• Plug into D (or S): P=30-3(5)  P*=15

D
5

Quantity (Q)
Q* = 5
EXAMPLE: TAX ON PRODUCER
Price per
gallon (P)
• Now there is a tax on producer of $4
• No tax: set PS=PD
• With producer tax: set PS=PD-tax
• Solve 10+Q=30-3Q-4  Q*=4

PD = $18
• Note: no longer have just one P!
P = $15
• PD=30-3Q  PD=18
PS = $14 • PS=PD-tax  PS=14

• Sticker price is $18, but producer only

keeps $14
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Q* = 4 Quantity (Q)
ECONOMIC INCIDENCE

• Who bears the economic incidence of the tax?

• Consumer burden = (P1-P0) + tax paid by consumer
= 18 – 15 + 0 = $3
• Producer burden = (P0-P1) + tax paid by producer
= 15 – 18 + 4 = $1

• Consumer bears 75% of the burden even though 100% is levied on producer!

• Incidence Rule #1: statutory incidence ≠ economic incidence

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 EXAMPLE: TAX ON CONSUMER
Price per
gallon (P)
• Instead, $4 tax on the consumer
• With consumer tax: set PD=PS+tax
Consumer Burden
• Solve 30-3Q=10+Q+4  Q*=4

PD = $18 • Solve for PS and PD

P = $15 • PD=30-3Q  PD=18
PS = $14 • PS=PD-tax  PS=14

Producer Burden
• Sticker price is $14, but consumer
pays the $4 tax now
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Q* = 4 Quantity (Q)
ECONOMIC VS. STATUTORY INCIDENCE

• Who bears the economic burden?

• Consumer burden = (P1-P0) + tax paid by consumer
= 14 – 15 + 4 = $3
• Producer burden = (P0-P1) + tax paid by producer
= 15 – 14 + 0 = $1

• Incidence Rule #2: economic incidence is independent of statutory incidence –

i.e., the distribution of the tax's burden does not depend on who the tax is
levied on

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 EXAMPLE: PERFECTLY ELASTIC DEMAND
Price per
gallon (P)

• Consider a $4 producer tax with

perfectly elastic demand
• Demand: PD=15
• Supply: PS=10+QS

P = PD = $15
• Solve PS=PD-tax 10+Q=15-4  Q*=1
PS = $11
• PS=$11 and PD=$15
• Producer burden = $4 (100% of the tax!)
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Q* = 1 Quantity (Q)
 EXAMPLE: PERFECTLY INELASTIC DEMAND
Price per
gallon (P)
• Now consider a $4 producer tax with
perfectly inelastic demand
• Demand: QD=5
• Supply: PS=10+QS
PD = $19

PS = $15 • Here the tax is shifted fully to the

consumer
• PS=$15
• PD=$19
• Producer burden = $0
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Q* = 5 Quantity (Q)
INCIDENCE AND SUPPLY ELASTICITIES
• Similar concept for tax incidence and elasticity of supply. Again, let’s consider a tax on
producers:

• Inelastic supply:
• Small change in sticker price, i.e., producer bears higher burden
• Elastic supply: 12

• Large change in sticker price, i.e., consumer bears higher burden

TAX INCIDENCE AND ELASTICITIES

• What determines who bears the burden of the tax?

• Answer: relative elasticities of supply and demand

• Incidence Rule #3: the less elastic agent bears the higher tax burden
• E.g., if demand is very elastic, it means consumers are very price sensitive  producers
must take on some of the tax burden in order to continue to trade

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TAX INCIDENCE AND MARKET STRUCTURE

• Suppose a tax is levied on a producer who is a monopolist

• Recall that all firms maximize profits by producing until MR=MC (marginal
revenue = marginal cost)
• Competitive market: MR=market price  produce until MC=P
• Monopoly: MR≠P

• Monopolies are price makers, not price takers

• Question: will the monopolist fully pass the tax on to the consumer?
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TAX INCIDENCE AND MARKET STRUCTURE
• Example: Competitive market
• MC=$6; D: P=30-3Q; Tax of $6 on producer
• Now marginal cost is original MC plus the tax

Price (P) Competitive Market (P=MC)

• With tax: set P=MC+tax
• 30-3Q=6+6  Q*=6, P*=12
P=12 MC+Tax • Pass 100% to consumer
P=6 MC

D
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Q=6 Quantity (Q)

TAX INCIDENCE AND MARKET STRUCTURE

• Now consider a monopolist: MC=$6; D: P=30-3Q

• Note: MR=30-6Q (twice the slope of demand)

Price (P)
Monopoly (pre-tax)
• Set MR=MC: 30-6Q=6 Q=4
P=18 • Plug Q into demand: 30-3(4)=18
6 MC

D
MR 16

Q=4 Quantity (Q)

EXAMPLE: MONOPOLY

• Example: MC=$6; D: P=30-3Q; MR=30-6Q

• Now $6 tax levied on the monopolist
Monopoly (+$6 producer tax)
Price (P) • Set MR=MC+tax: 30-6Q=6+6 Q=3
• Plug Q into demand: P=30-3(3)=21

P=21 • Pass on $3 to consumer (50% burden)

12 MC+tax • Monopoly power does not mean passing
on 100% of the burden!
6 MC

• Additionally, rules of tax incidence

follow with monopolists as well (try at
D home with consumer tax)
MR 17

Q=3 Quantity (Q)

DETERMINANTS OF ELASTICITIES

• What makes supply/demand more elastic?

• Demand: availability of substitutes
• Supply: ease of exit/entry into the market
• Both: time horizon

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TAX INCIDENCE AND SIN TAXES

• “Sin taxes” are commodity taxes levied on goods associated with externalities
to discourage consumption
• Idea: tax on the good  increase price of the good  decrease consumption

• But given the tax incidence rules, will this always be the case? Consider the
following examples…

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CIGARETTE TAXES

• Cigarette taxes in the US are primarily excise taxes levied on the producer

• Estimated elasticity of demand: between -.3 and -.5, i.e. a 10% increase in the
price of cigarettes decreases cigarette purchases by 3-5% (i.e., demand is inelastic)
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• Result: tax is levied on the producer, but passed on to the consumer

CANDY TAXES

• Several states recently passed legislation charging taxes on candy

• Primarily takes the form of a lack of sales tax exemption for candy, but not other food

• Will the consumer or producer bear the burden of the tax?

• Other snacks and desserts are untaxed, so many substitutes
• Additionally, definition of candy is very narrow…

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PLASTIC BAG TAXES

• Several municipalities recently passed legislation charging taxes on plastic bags

• e.g., as of 2010, D.C. charges 5-cents per paper or plastic bag

• Two important design components:

• Charge for paper AND plastic (tax close substitute)
• Tax must be passed on to the consumer

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FINAL EXAM

• Final Exam: Dec 15th, 4:55-6:35pm

• Location: Bobst LL1.50

• Practice: Exam review questions & recitation (Aaron’s session tonight, Brittany’s
review added to her weekend review session)

• Review sessions:
• Aaron: Saturday, Dec 11, 11:00-12:30
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• Brittany: Sunday, Dec 12, 3:00-5:00
EXAM TOPICS

• Insurance models
• Health Insurance
• Unemployment Insurance and Social Security
• Personal Income Taxes
• Taxation and Labor Supply
• Tax Efficiency
• Tax Incidence

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ECONOMICS CLASSES AT WAGNER

• Methods classes:
• PADM-GP 2875: Estimating Impacts
• PADM-GP 2172: Advanced Empirical Methods
• PADM-GP 4502: Using Large Data Sets in Policy Research

• Topics classes
• PADM-GP 2139: Behavioral Economics and Policy Design
• PADM-GP 2203: International Economic Development
• PADM-GP 2441:The Economics of Education
• HPAM-GP 4865: Public Policy and Obesity
• HPAM-GP 4830/4831: Health Economics
• URPL-GP 2608: Urban Economics 25

• PADM-GP 2138: Macroeconomics

• Course evaluations: Please take the time to fill these out!

• Thank you for a wonderful semester and have a great winter break!

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