CHAPTER 14

TAXATION AND
INCOME
DISTRIBUTION

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Vocabulary
 Statutory Incidence
 Economic Incidence
 Tax Shifting
 Partial Equilibrium Models

14-2
Tax Incidence: General Remarks
 Only people can bear taxes
 Functional distribution of income
 Size distribution of income
 Both sources and uses of income should be considered
 Incidence depends on how prices are determined
 Incidence depends on the disposition of tax revenues
 Balanced-budget tax incidence
 Differential tax incidence
 Lump-sum tax
 Absolute tax incidence

14-3
Tax Progressiveness Can Be Measured in Several Ways

 Average tax rate versus Tax Liabilities under a hypothetical tax

marginal tax rate system
Income Tax Average Marginal
 Proportional tax system Liability Tax Rate Tax Rate
$2,000 -$200 -0.10 0.2
 Progressive tax system 3,000 0 0 0.2
5,000 400 0.08 0.2
 Regressive tax system
10,000 1,400 0.14 0.2
30,000 5,400 0.18 0.2

14-4
Measuring How Progressive a Tax System is

T1 T0 T1  T0
I1  I0
v1  v2 
T0
I1  I 0 I1  I 0
I0

14-5
Measuring How Progressive a Tax System is – A
Numerical Example
T1 T0 T1  T0
I1  I0 T0
v1  v2 
I1  I 0 I1  I 0
I0
3 0 0 2 0 0

3 00 200
.0 0 0 2 5  10 00 8 00
2 .0  200
1000 800 1 0 0 0 8 0 0
800

3 6 0 2 4 0

36 0 240
.0 0 0 3  1 0 00 8 00
2 .0  240
1000 800 1 0 0 0 8 0 0
800
14-6
$
2.60
Before Tax After

2.40
Partial Equilibrium Models Tax

Consumers Pay
$1.20 $1.40

2.20
Suppliers Receive $1.00
$1.20

S1
2.00

S0
1.80

1.60

1.40

1.20

1.00

0.80

D0
0.60
0 1 2 3 4 5 6 7 8
D1 Quantity
14-7
$
2.6

SX
2.4

2.2

S
1.8

1.6

1.4

1.2

Perfectly
0.8 Inelastic
D’
Supply X DX
0.6
0 1 2 3 4 5 6 7 14-88
Quantity
$
2.6

2.4

2.2

S
1.8

1.6

Perfectly
1.4 Elastic
Supply SX
1.2

0.8
DX ’
DX
0.6
0 1 2 3 4 5 6 7 14-98
Quantity
Ad Valorem Taxes
Price per Pound of food

Sf

Pr

P0

Pm

Df
Df’
Qr Q0 Qm Pounds of food
14-10
per year
Taxes on Factors
 The Payroll Tax
 Capital Taxation in a Global Economy

14-11
Commodity Taxation without Competition
 Monopoly
 Oligopoly

14-12
Profits Taxes
 Economic profit
 Perfect competition
 Monopoly
 Measuring economic profit

14-13
Tax Incidence and Capitalization

PR = $R0 + $R1/(1 + r) + $R2/(1 + r)2 + … +

$RT/(1 + r)T
PR’ = $(R0 – u0) + $(R1 – u1)/(1 + r) + $(R2 –
u2)/(1 + r)2 + … + $(RT – uT)/(1 + r)
u0 + u1/(1 + r) + u2/(1 + r)2 + … + uT/(1 + r)T
Capitalization

14-14
General Equilibrium Models
 Partial equilibrium
 General equilibrium

14-15
Tax Equivalence Relations
tKF = a tax on capital used in the production of food
tKM = a tax on capital used in the production of manufactures
tLF = a tax on labor used in the production of food
tLM = a tax on labor used in the production of manufactures
tF = a tax on the consumption of food
tM = a tax on consumption of manufactures
tK = a tax on capital in both sectors
tL = a tax on labor in both sectors
14-16
Tax Equivalence Relations
 Partial factor taxes

tKF and tLF are equivalent to tF

and and and

tKM and tLM are equivalent to tM

are are are

equivalent equivalent equivalent
to to to
tK and tL are equivalent to t
Source: McLure [1971].

14-17
The Harberger Model
 Assumptions
 Technology
 Elasticity of substitution
 Capital intensive
 Labor intensive
 Behavior of factor suppliers
 Market structure
 Total factor supplies
 Consumer preferences
 Tax incidence framework

14-18
Analysis of Various Taxes
 Commodity tax (tF)
 Income tax (t)
 General tax on labor (tL)
 Partial factor tax (tKM)
 Output effect
 Factor substitution effect

14-19
Some Qualifications
 Differences in individuals’ tastes
 Immobile factors
 Variable factor supplies

14-20
An Applied Incidence Study
Table 14.3 Average federal tax rates and share of federal taxes
by income quintile (2006)

Average Federal Share of

Income Category Tax Rate Federal Taxes
Lowest Quintile 5.6% 1.1%
Second Quintile 12.1 5.2
Third Quintile 15.7 10.3
Fourth Quintile 19.8 19.0
Highest Quintile 26.5 64.2
All Quintiles 21.6 100.0
Top 1% 31.2 21.3
Source: Congressional Budget Office [2004]. These figures are based on
projections that rely on assumptions about inflation and income growth.
They include all tax law as of 2001.

14-21
The Payroll Tax
SL
Wage rate per hour

Pr

wg = w0

wn

DL
DL’
L0 = L1 Hours per year 14-22
Monopoly
$

MXX
Economic
Economic Profits
c
P0 Profits a
after unit ATCX
Pn
i tax f
dh g b
ATC0

DX

MRX DX’

X1 X0 MRX’ X per year

14-23