Public Economics

Unit IV: General Equilibrium Analysis

 Introduction
the economy is an interdependent system in which
all prices are related to each other.
Changes in the price and quantity of one product or
factor affect those of others.
 Product Taxes
a product tax leads to a rise in the price of the taxed
product and to a decline in its quantity.
Thus consumers of the taxed product are burdened
from the uses side and suppliers from the sources
side.
 Product Taxes
Turning now to repercussions in other markets, we see
that two further chains of adjustment result:
As consumers buy less of the taxed product, the
demand for other products is increased.
If production is subject to increasing cost, this will raise
their price, while lowering that of the taxed product.
Thus, the burden from the uses side will be spread to
consumers of other products.
 Product Taxes
 As the output mix changes, so does the derived demand for
various factors of production.
 Suppose that the taxed product is highly capital-intensive
while products which are substituted for it are labor-
intensive.
 Such substitution leads to an increase in the return to labor
and a decrease in the return to capital.
 As a result, further effects from the earnings side come about.
 Must we then conclude that nothing can be said about incidence?
 Reasoning in the partial equilibrium setting, we concluded with a
strong presumption that the uses effect of product taxes is controlling,
so that substitution of a tax on luxuries for a tax on necessities will
render the tax structure more progressive, and vice versa.
 We argued that unless there is specific evidence to the contrary, the
burden pattern on the uses side will not be canceled out by indirect
effects on the sources side and vice versa.
 Allowing for the general equilibrium setting, we must now assume
further that secondary adjustments in other product and factor
markets being broadly diffused, will follow a more or less neutral
pattern.
 Factor Taxes
 As the supply of the taxed factor falls off, the relative scarcity
of other factors declines.
 As a result, their rates of return will fall.
 Thus, the impact on the earnings side, initially centered on the
taxed factor, comes to be shared to some extent by other
factors.
 An especially important aspect of this mechanism arises with
the effects of capital taxes on capital accumulation, an aspect of
tax incidence which we will consider further later on.
As the prices of products which draw heavily upon
the taxed factor rise, their consumers will be
burdened.
As they tend to substitute other products, the prices
of such products will rise, thus spreading the burden
impact from the uses side among a broader group of
consumers.
THE END