Taxes CHAPTER 8

CHAPTER CHECKLIST

When you have completed your study of this

chapter, you will be able to

1 Explain how taxes change prices and quantities, are

shared by buyers and sellers, and create inefficiency.
2 Explain how income taxes and Social Security taxes
change wage rates and employment, are shared by
employers and workers, and create inefficiency.
3 Review ideas about the fairness of the tax system.
8.1 TAXES ON BUYERS AND SELLERS

Tax Incidence
Tax incidence is the division of the burden of a tax
between the buyer and the seller.
When a good is taxed, it has two prices:
• A price that includes the tax
• A price that excludes the tax
Buyers respond to the price that includes the tax.
Sellers respond to the price that excludes the tax.
8.1 TAXES ON BUYERS AND SELLERS

The tax is like a wedge between the two prices.

Suppose that the government puts a $10 tax on MP3
players.
How does the price paid by the buyer change?
How does the price received by the seller change?
How is the burden of a tax shared between the buyer
and the seller?
8.1 TAXES ON BUYERS AND SELLERS

Figure 8.1(a) shows what

happens when the
government taxes buyers
of the MP3 players.
1. With no tax, the price
is $100 and 5,000
players are bought.

2. A $10 tax on buyers

shifts the demand curve
to D – tax.
 8.1 TAXES ON BUYERS AND SELLERS

3. The buyer’s price rises

to $105—an increase
of $5 a player.

4. The seller’s price falls

to $95—a decrease of
$5 a player.
5. The quantity decreases
to 2,000 players a week.
6. The government’s tax
revenue is $20,000.
8.1 TAXES ON BUYERS AND SELLERS

Figure 8.1(b) shows what

happens when the
government taxes sellers
of the MP3 players.

1. With no tax, the price is

$100 and 5,000 players
a week are bought.

2. A $10 tax on sellers of

MP3 players shifts the
supply curve to S + tax.
 8.1 TAXES ON BUYERS AND SELLERS

3. The buyer’s price rises

to $105—an increase
of $5 a player.

4. The seller’s price falls

to $95—a decrease
of $5 a player.
5. The quantity decreases
to 2,000 players a
week.
6. The government’s tax
revenue is $20,000.
8.1 TAXES ON BUYERS AND SELLERS

Taxes and Efficiency

A tax places a wedge between the buyers’ price
(marginal benefit) and the sellers’ price (marginal cost).
The equilibrium quantity is less than the efficient
quantity and a deadweight loss arises.
 8.1 TAXES ON BUYERS AND SELLERS

Figure 8.2 shows the

inefficiency of taxes.
In Figure 8.2(a), the market is
efficient with marginal benefit
equal to marginal cost.

Total surplus—the sum of

2. Consumer surplus and
3. Producer surplus—is
maximized.
 8.1 TAXES ON BUYERS AND SELLERS
Figure 8.2(b) shows how
taxes create inefficiency.
A $10 tax shifts the supply
curve to S + tax.

1. Marginal benefit exceeds

2. Marginal cost.
3. Consumer surplus and
4. Producer surplus shrink.

5. The government collects

its tax revenue.
6. A deadweight loss arises.
 8.1 TAXES ON BUYERS AND SELLERS

The loss of consumer

surplus and producer
surplus is the burden of
the tax.

The burden of the tax

equals the tax revenue
plus the deadweight
loss.
8.1 TAXES ON BUYERS AND SELLERS

Excess burden is the

deadweight loss from a
tax.
The excess burden is
(3,000  $10  2), which
equals $15,000.
Excess burden is the
amount by which the
burden of a tax exceeds
the tax revenue received
by the government.
8.1 TAXES ON BUYERS AND SELLERS

Incidence, Inefficiency, and Elasticity

The incidence of a tax and its excess burden depend on
the elasticites of demand and supply:
• For a given elasticity of supply, the buyer pays a
larger share of the tax, the more inelastic is the
demand for the good.
• For a given elasticity of demand, the seller pays a
larger share of the tax, the more inelastic is the
supply of the good.
• Excess burden is smaller, the more inelastic is
demand or supply.
8.1 TAXES ON BUYERS AND SELLERS

Tax Incidence, Inefficiency, and Elasticity of

Demand
Perfectly Inelastic Demand: Buyer Pays and Efficient
Perfectly Elastic Demand: Seller Pays and Inefficient
Figures 8.3(a) and 8.3(b) illustrate these two extreme
cases.
8.1 TAXES ON BUYERS AND SELLERS

Figure 8.3(a) shows tax

incidence in a market with
perfectly inelastic demand—
the market for insulin.

A tax of 20¢ a dose raises the

price by 20¢, and the buyer
pays all the tax.

Marginal benefit equals

marginal cost, so the outcome
is efficient.
8.1 TAXES ON BUYERS AND SELLERS

Figure 8.3(b) shows tax

incidence in a market with
perfectly elastic demand—
the market for pink pens.
A tax of 10¢ a pink pen
lowers the price received by
the seller by 10¢, and the
seller pays all the tax.

A deadweight loss arises, so

the outcome is inefficient.
8.1 TAXES ON BUYERS AND SELLERS

Tax Incidence, Inefficiency, and Elasticity of

Supply
Perfectly Inelastic Supply: Seller Pays and Efficient
Perfectly Elastic Supply: Buyer Pays and Inefficient
Figures 8.4(a) and 8.4(b) illustrate these two extreme
cases.
8.1 TAXES ON BUYERS AND SELLERS
Figure 8.4(a) shows tax
incidence in a market with
perfectly inelastic supply—the
market for spring water.
A tax of 5¢ a bottle does not
change the price paid by the
buyer but lowers the price
received by the seller by 5¢.
Marginal benefit equals
marginal cost, so the outcome
is efficient.
The seller pays the entire tax.
8.1 TAXES ON BUYERS AND SELLERS

Figure 8.4(b) shows tax

incidence in a market with
perfectly elastic supply—the
market for sand.
A tax of 1¢ a pound
increases the price by 1¢ a
pound, and the buyer pays
all the tax.
A deadweight loss arises, so
the outcome is inefficient.
8.2 INCOME TAX AND SOCIAL SECURITY TAX

The Personal Income Tax

In 2004, the personal income tax raised:
•More than $1 trillion for the federal government
•About $300 billion for state and local governments
The amount of income tax that a person pays depends
on her or his taxable income and on the tax rates.
Taxable income is total income minus a personal
exemption and a standard deduction (or other allowable
deductions).
8.2 INCOME TAX AND SOCIAL SECURITY TAX

Marginal tax rate is the percentage of an additional

dollar of income that is paid in tax.

Average tax rate is the percentage of income that is

paid in tax.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
A tax can be progressive, proportional, or regressive.

A progressive tax is a tax whose average rate

increases as income increases.

A proportional tax is a tax whose average rate is

constant at all income levels.

A regressive tax is a tax whose average rate

decreases as income increases.
8.2 INCOME TAX AND SOCIAL SECURITY TAX

Figure 8.5 shows

U.S. tax rates in 2006.

1. Marginal tax
rate increases
with income.
2. Average tax rate
increases with
income
The personal income
tax is a progressive
tax.
8.2 INCOME TAX AND SOCIAL SECURITY TAX

The Effects of the Income Tax

Tax on Labor Income
Firms can substitute machines for labor, so the demand
for labor is elastic.
Most people must work for their income, so the supply
of labor is inelastic.
With elastic demand and inelastic supply, the worker
bears the greater burden of the income tax.
 8.2 INCOME TAX AND SOCIAL SECURITY TAX
Figure 8.6 shows the effects of
a tax on labor income.
1. Workers pay a 20 percent
marginal income tax rate.
The supply of labor decreases,
the wage rate rises, and the
after-tax wage rate falls.
2. The employer pays some of
the tax.
3. The worker pays most of the
tax.
4. A deadweight loss arises.
8.2 INCOME TAX AND SOCIAL SECURITY TAX

Taxes on Capital Income

Taxing the income from capital works like taxing the
income from labor.
One crucial difference: capital is internationally mobile
and so the supply of capital is highly elastic—perhaps
perfectly elastic.
 8.2 INCOME TAX AND SOCIAL SECURITY TAX
Figure 8.7 shows the effect of
a tax on capital income.
1. The supply of capital is
perfectly elastic.
2. With a 40 percent tax on
capital income, the interest
rate rises.
3. The firm pays the entire tax.

4. A large deadweight loss

arises.
8.2 INCOME TAX AND SOCIAL SECURITY TAX

Taxes on Income from Land and Unique Resources

Works in the same way as taxing the income from other
sources except for one crucial difference.
The supply of land is highly inelastic.
The tax on land income is fully borne by the landowners
and the quantity of land is unaffected by the tax.
With no change in the quantity of land, the tax on land
income creates no deadweight loss or excess burden and
is efficient.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
Figure 8.8(a) shows a tax
on income from land.
1. Supply is perfectly inelastic.

2. With a 40 percent tax, the

supply of land is
unchanged and the market
rent is unchanged.

3. The landowner pays the

entire tax.

No deadweight loss arises—

the tax is efficient.
 8.2 INCOME TAX AND SOCIAL SECURITY TAX

Figure 8.8(b) shows a high tax

rate on Oprah’s income.

1. Supply is perfectly inelastic.

2. With a 40 percent tax, the
supply curve is unchanged
and the market price is
unchanged.
3. Oprah pays the entire tax.
No deadweight loss arises and
the tax is efficient.
8.2 INCOME TAX AND SOCIAL SECURITY TAX

The Social Security Tax

The Social Security tax law says that the tax is to be

shared equally by workers and employers.
But the principles that determine the incidence of other
taxes you’ve studied in this chapter also apply to the
Social Security tax.
We look at two extreme Social Security taxes: one on
workers only and one on employers only.
 8.2 INCOME TAX AND SOCIAL SECURITY TAX
A Social Security Tax
on Workers
With no taxes, the wage
rate is $12.00 an hour
and 4,000 people are
employed.

1. A 20 percent Social
Security tax on workers
shifts the supply curve
to LS + tax.
8.2 INCOME TAX AND SOCIAL SECURITY TAX

2. The wage rate paid by

employers rises to
$12.50 an hour—an
increase of 50¢ an
hour.
3. The number of people
employed decreases
to 3,000.
4. Workers receive $10.00
an hour—a decrease of
$2 an hour.
8.2 INCOME TAX AND SOCIAL SECURITY TAX

5. The government
collects tax revenue
shown by the purple
rectangle.

Workers pay most of the

tax because the supply
of labor is more inelastic
than the demand for
labor.
8.2 INCOME AND SOCIAL SECURITY TAX

A Social Security Tax on Employers

Payroll tax is a tax on employers based on the wages

they pay their workers.

Figure 8.10 on the next slide shows the effects of a

payroll tax.
 8.2 INCOME TAX AND SOCIAL SECURITY TAX

A Social Security Tax

on Employers

With no tax, the wage

rate is $12.00 an hour
and 4,000 people are
employed.
1. A tax on employers of
$2.50 an hour shifts
the demand curve to
LD – tax.
8.2 INCOME TAX AND SOCIAL SECURITY TAX

2. The wage rate falls

to $10.00 an hour—
a decrease of $2.00
an hour.

3. The number of
workers employed
decreases to 3,000.
 8.2 INCOME TAX AND SOCIAL SECURITY TAX

4. Employers’ total cost

of labor rises to
$12.50 an hour—the
$10.00 wage rate
plus the $2.50 tax.

5. The government
collects tax
revenue shown by
the purple
rectangle.
8.3 FAIRNESS AND THE BIG TRADEOFF

Whenever political leaders debate tax issues, it is

fairness, not efficiency, that looms above all other
considerations.
There are two conflicting principles of fairness of taxes:
• The benefits principle
• The ability-to-pay principle
8.3 FAIRNESS AND THE BIG TRADEOFF

The Benefits Principle

The benefits principle is the proposition that people
should pay taxes equal to the benefits they receive from
public goods and services.
This arrangement is fair because it means that those
who benefit most pay the most.
But to implement it, we would need an objective way of
measuring each person’s marginal benefit from public
goods and services.
8.3 FAIRNESS AND THE BIG TRADEOFF

The Ability-to-Pay Principle

The ability-to-pay principle is the proposition that
people should pay taxes according to how easily they
can bear the burden.
A rich person can more easily bear the burden of
providing public goods than a poor person can, so the
rich should pay higher taxes than the poor.
This principle compares people according to
• Horizontal equity
• Vertical equity
8.3 FAIRNESS AND THE BIG TRADEOFF

Horizontal equity is the requirement that taxpayers

with the same ability to pay the same taxes.

Vertical equity is the requirement that taxpayers with

a greater ability to pay bear a greater share of the
taxes.
8.3 FAIRNESS AND THE BIG TRADEOFF

The Marriage Tax Problem

• In the U.S. tax code, a married couple is considered a
single taxpayer.
• This arrangement means that if they each earn the
same income as before a marriage, the married
couple might pay more tax than they did before
marriage.
8.3 FAIRNESS AND THE BIG TRADEOFF

The Big Tradeoff

Questions about the fairness of taxes conflict with
efficiency questions and create the big tradeoff.
Taxes on capital incomes create the greatest
deadweight loss—are the most inefficient.
But most of the capital is owned by a small number of
rich people, so (most people believe) taxes on capital
are the fairest.
Our tax system is an evolving attempt to juggle the two
goals of efficiency and fairness.