Chapter 6

Public Finance and Public Policy Jonathan
CopyrightGruber
© 2010Fourth
WorthEdition
Publishers
Copyright © 2012 Worth Publishers 1 of 35
Tax Incidence and
Inefficiencies 6
6.1 The Three Rules of Tax Incidence
6.2 Tax Incidence Extensions
6.3 Taxation and Economic Efficiency
6.4 Optimal Taxation
PREPARED BY
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 2 of 35
CHAPTER 19 ■ THE EQUITY IMPLICATIONS OF TAXATION: TAX INCIDENCE
6.1
Tax Incidence
Sources of federal government revenue, 1960 and 2008:

Category: 1960 2008
Income taxes 44.5% 43.7%
Corporate taxes 22.8 11.3
Payroll tax 17.0 37.8
Excise taxes 12.8 2.6
Other 2.9 4.5
• Tax incidence: Assessing which party (consumers or

producers) bears the true burden of a tax.
6.1
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.
6.1
Who Really Bears the Tax
• The tax burden for consumers is:
Consumer tax burden =

(post-tax price – pre-tax price) + per-unit consumer tax
• For producers the tax burden is
Producer tax burden =

(pre-tax price – post-tax price) + per-unit producer tax
6.1
Burden of the Tax on Consumers and Producers
• Tax wedge: The difference between what consumers

pay and what producers receive (net of tax) from a
transaction.
• If the consumer burden is $0.30 and the producer
burden is $0.20, the tax wedge is $0.50.
6.1
Who Really Bears the Tax, and Is Irrelevant to the
Tax Burden
(a) Tax on producers S2 (b) Tax on consumers

Price per Price per
gallon (P) gallon (P)
S1 S
Tax =
B $0.50
P2 = $2.00
Consumer D E
P3 = $1.80 $1.80
burden =
C Consumer
$0.30 P1 = $1.50 A P1 = $1.50 A
burden =
Producer $0.30 C
burden = $1.30 P3 = $1.30
E Producer
$0.20 D Tax =
burden = P2 = $1.00
$0.20 B $0.50
D D1
D2
0 Q2 = 80 Q3 = 90 Q1 = 100 Quantity in 0 Q1 = 100 Quantity in
billions of billions of
gallons (Q) gallons (Q)
6.1
Gross versus After-Tax Prices
• Gross price: The price in the market.

• After-tax price: The gross price minus the amount of
the tax (if producers pay the tax) or plus the amount of
the tax (if consumers pay the tax).
• Different statutory rules produce different gross prices
for the same after-tax price.
6.1
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 there is full shifting of the tax burden to it.
o Full shifting: When one party in a transaction
bears all of the tax burden.
6.1
Perfectly Inelastic Demand
6.1
Perfectly Elastic Demand
6.1
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.
6.1
Supply Elasticities
6.1
Reminder: Tax Incidence Is About Prices, Not
Quantities
• When the demand for gas is perfectly elastic,

consumers bear none of the burden of taxation, yet
the quantity of gas consumed fell dramatically.
• Doesn’t this fall in consumption hurt consumers?
• If so, shouldn’t tax incidence take that into account?
• Perfectly elastic demand means consumers are
indifferent between the gas and other goods, so they
are not hurt by the fall in gas consumption.
6.2
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.
6.2
Tax Incidence in Factor Markets
6.2
Impediments to Wage Adjustment
• Tax incidence analysis assumes that prices can freely

adjust.
• But wages cannot fall below the minimum wage.
• Minimum wage: Legally mandated minimum
amount that workers must be paid for each hour of
work.
• Barriers to price adjustment change the incidence.
6.2
Impediments to Wage Adjustment
(a) Tax on workers (b) Tax on firms

Wage S2 Wage
(W) (W)
S1
Firm S1
Tax = B
burden = W2 = $8.25
$0.50 $1.00 Firm
W2 = $7.75 B burden =
$1.00 C’ A
A WM = $7.25
WM = $7.25
C
W3 = $6.75 $6.75
C Tax =
Worker $1.00
burden =
D1 D2 D1
$0.50
0 H2 H1 Hours of 0 H3 H2 H1 Hours of
labor (H) labor (H)
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.
6.3
Tax Inefficiencies and Their Implications for Optimal
Taxation
• Usually, the market produces efficient outcomes.

• Taxes interfere in the market and reduce efficiency.
• People substitute away from the taxed product, using
less-efficient alternatives.
o Eight-person motorcycles in Indonesia
• Some taxes have much larger efficiency costs than
others.
6.3
Taxation and Economic Efficiency: Graphical
Approach
Price per S2
gallon (P)
S1
Tax =
$0.50
B
P2 = $1.80
E Deadweight loss, DWL
P1 = $1.50 A
F D
P3 = $1.30 C
G
D1
0 Q2 = 90 Q1 = 100 Quantity in
billions of
gallons (Q)
6.3
Taxation and Economic Efficiency
• Absent taxes:
price = social marginal benefit = social marginal cost
• The tax drives a wedge between SMB and SMC,
preventing mutually beneficial trades from occurring.
• The units between 90 and 100 would have generated a
consumer and producer surplus.
• The foregone surplus from taxation is called the
deadweight loss (DWL).
• The size of the DWL depends on elasticities.
6.3
Elasticities Determine Tax Inefficiency
(a) Inelastic demand (b) Elastic demand

Price per
S2 Price per
S2
gallon (P) gallon (P)
S1 S1
Tax Tax
B
P2 B
DWL P2
A
P1
P1
C A
C D1
DWL
D1
0 Q2 Q1 Quantity in 0 Q2 Q1 Quantity in
billions of billions of
gallons (Q) gallons (Q)
6.3
Elasticities Determine Tax Inefficiency
• Deadweight loss is caused by individuals and firms

making inefficient consumption and production
choices in order to avoid taxation.
• The inefficiency of any tax is determined by the extent
to which consumers and producers change their
behavior to avoid the tax.
• The more elastic is demand or supply, the larger the
DWL.
6.3
APPLICATION: Tax Avoidance in Practice
Keynes: “The avoidance of taxes is the only pursuit that

still carries any reward.” Some examples of avoidance:
1. The Papal States taxed salt heavily, so Tuscan bakers
stopped using it. Even today, Tuscan bread is saltless.
2. In the early 1980s, Cyprus’s building tax applied to
finished structures. Homeowners put steel bars jutting
out from their roofs to avoid the tax.
3. Thailand taxes business signs on the outside, with
higher taxes for English-only signs. So many signs have
a bit of Thai writing in the corner, or are hung on
curtains inside the shop.
6.3
Determinants of Deadweight Loss
• The formula for DWL is

𝜂𝑠 𝜂𝑑 2
𝑄
𝐷𝑊𝐿 = − ×𝜏
2 𝜂𝑠 − 𝜂 𝑑 𝑃
o 𝜂𝑠 and 𝜂𝑑 are the elasticity of supply and
demand, 𝜏 is the tax rate, Q and P are the quantity
and price.
• DWL rises with the square of the tax, so marginal DWL
rises with the tax rate.
o Marginal deadweight loss: The increase in
deadweight loss per unit increase in the tax.
6.3
Marginal DWL Rises with Tax Rate
S3
Price Tax =
of gas $0.10 S2
D S1
P3
B
P2 Tax =
$0.10
P1 A
DWL
C
E
D1
0 Q3 Q2 Q1 Quantity of gas
6.4
Ramsey Model
A simplified version of the Ramsey rule is the “inverse-

elasticity rule.” This rules states that tax rates on goods
should be inversely related to their elasticity of demand.
6.4
Equity Implications of the Ramsey Model
Imagine that the government had only two goods it could

tax, cereal and caviar:
• Elasticity of demand for caviar is much higher than
that for cereal.
• The inverse elasticity rule would suggest that the
government tax cereal much more highly than caviar.
• This means taxing the good consumed by poor
people more heavily.
• This might hurt vertical equality.
6.4
Deadweight loss vs. tax revenue
With each increase in the tax rate, the deadweight loss of

the tax rises even more rapidly than the size of the tax.
• For the small tax, tax revenue is small.
• As the size of the tax rises, tax revenue grows.
• But as the size of the tax continues to rise, tax
revenue falls because the higher tax reduces the size
of the market.
6.4
(a) Small Tax
Price
Deadweight
loss Supply
PB
Tax revenue
PS
Demand
0 Q2 Q1 Quantity
6.4
(b) Medium Tax
Price
Deadweight
PB loss
Supply
Tax revenue
PS Demand
0 Q2 Q1 Quantity
6.4
(c) Large Tax
Price
PB
Deadweight
loss
Supply
Tax revenue
Demand
PS
0 Q2 Q1 Quantity
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers
Copyright © 2004 South-Western 33 of 35
6.4
The Laffer Curve
Conclusion
• The fundamental issue in designing tax policy is the

equity-efficiency trade-off.
• Tax efficiency comes down to two key principles:
o The more elastically supplied or demanded the
good, the larger the deadweight loss from the tax.
o The higher the tax rate, the larger the incremental
deadweight loss of taxation.

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Chapter 6

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Public Finance and Public Policy Jonathan

Sources of federal government revenue, 1960 and 2008:

• Tax incidence: Assessing which party (consumers or

• Statutory incidence: The burden of a tax borne by the

• The tax burden for consumers is:

Consumer tax burden =

• For producers the tax burden is

Producer tax burden =

• Tax wedge: The difference between what consumers

(a) Tax on producers S2 (b) Tax on consumers

• Gross price: The price in the market.

• The economic incidence of taxation does not depend

• In general, the less elastic is demand relative to supply,

• When the demand for gas is perfectly elastic,

• Tax incidence analysis assumes that prices can freely

(a) Tax on workers (b) Tax on firms

• The “fairness” of any tax reform is one of the primary

• Usually, the market produces efficient outcomes.

(a) Inelastic demand (b) Elastic demand

• Deadweight loss is caused by individuals and firms

Keynes: “The avoidance of taxes is the only pursuit that

• The formula for DWL is

A simplified version of the Ramsey rule is the “inverse-

Imagine that the government had only two goods it could

With each increase in the tax rate, the deadweight loss of

• The fundamental issue in designing tax policy is the

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