Chapter 8 – Taxation and

Income Distribution

Public Finance

1
Introduction

• Many policies center around whether the

tax burden is distributed fairly.
• Not as simple as analyzing how much in
taxes each person actually paid, because
of tax-induced changes to price.

2
Introduction

• Two main concepts of how a tax is

distributed:
– Statutory incidence – who is legally
responsible for tax
– Economic incidence – the true change in
the distribution of income induced by tax.
– These two concepts differ because of tax
shifting.
3
Tax Incidence: General Remarks

• Only people can bear taxes

– Business paying their fair share simply shifts
the tax burden to different people.
– Can study people whose total income
consists of different proportions of labor
earnings, capital income, and so on.
– Sometimes appropriate to study incidence of
a tax across regions.
4
Tax Incidence: General Remarks

• Tax progressiveness can be measured in

a number of ways
– A tax is often classified as:
• Progressive
• Regressive
• Proportional
– Proportional taxes are straightforward: ratio
of taxes to income is constant regardless of
income level.
5
Tax Incidence: General Remarks

• Can define progressive (and regressive)

taxes in a number of ways.
• Can compute in terms of
– Average tax rate (ratio of total taxes total
income) or
– Marginal tax rate (tax rate on last dollar of
income)

6
Tax Incidence: General Remarks

• Measuring how progressive a tax system is

present additional difficulties. Consider two simple
definitions.
– The first one says that the greater the increase in
average tax rates as income rises, the more progressive
is the system.
T1
I1  T0
I0
v1 
I1  I 0
7
Tax Incidence: General Remarks

– The second one says a tax system is more progressive

if its elasticity of tax revenues with respect to income is
higher.
– Recall that an elasticity is defined in terms of percent
change in one variable with respect to percent change in
another one:

T1  T 0 
% T T0
v2    I1  I 0 
% I I0
8
Figure 8.1
Figure 8.2
Numerical Example

• Suppose the market for champagne is

characterized by the following supply and demand
curves:

Q S  20  2P
Q D  100  2P
11
Numerical Example

• If the government imposes a per-unit tax on

demanders of $8 per unit, the tax creates a wedge
between what demanders pay and suppliers get.
Before the tax, we can rewrite the system as:

Q S  2 0  2 PS
Q D  100  2 PD
PS  PD
12
Numerical Example

• After the tax, suppliers receive $8 less per pack

than demanders pay. Therefore:

PS  PD  D
PS  PD  8

13
Numerical Example

• Solving the initial system (before the tax) gives a

price of P=20 and Q=60. Solving the system after
the tax gives:

Q S  Q D  2 0  2  P D  8   1 0 0  2 P D
PD  2 4, PS  1 6,Q  5 2

14
Numerical Example

• In this case, the statutory incidence falls 100% on

the demanders, but the economic incidence is
50% on demanders and 50% on suppliers:

PD  P0 $24  $20
  0 .5
 $8

15
Partial Equilibrium Models:
Taxes on Suppliers versus Demanders

• Incidence of a unit tax is independent of

whether it is levied on consumers or producers.
• If the tax were levied on producers, the supplier
curve as perceived by consumers would shift
upward.
– This means that consumers perceive it is more
expensive for the firms to provide any given quantity.

• This is illustrated in Figure 8.3.

16
Figure 8.3
Partial Equilibrium Models:
Taxes on Suppliers versus Demanders

• Clearly, these equations are identical to each

other. The same quantity and prices will
emerge as before.
• Implication: The statutory incidence of a tax tells
us nothing about the economic incidence of it.
• The tax wedge is defined as the difference
between the price paid by consumers and the
price received by producers.
18
Figure 8.4
Figure 8.5
Partial Equilibrium Models:
Ad-valorem Tax

• Figure 8.7 shows an ad-valorem tax

levied on demanders.
• As with the per-unit tax, the demand
curve as perceived by suppliers has
changed, and the same analysis is used
to find equilibrium quantity and prices.

21
Figure 8.7
Numerical Example

• Returning to our previous example, with a per-unit

tax on demanders the system was written as:

Q S  2 0  2 PS
Q D  100  2 PD
PS  PD  D
23
Numerical Example

• Now, with an ad-valorem tax (τD), the system is

written as:

Q S  2 0  2 PS
Q D  100  2 PD
P S  1   D  P D
24
Numerical Example

• If the ad-valorem tax on demanders was 10%,

then relationship between prices is:

P S  0 .9 P D 
Q S  Q D  2 0  2  0 .9 P D   1 0 0  2 P D
P D  2 1 .0 5 , P S  1 8 .9 5 , Q  5 7 .8 9

25