The Economics of Public Policy 11. Tax Incidence and the Excess Burden of Taxation

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1 Fletcher School of Law and Diplomacy, Tufts University The Economics of Public Policy 11. Tax Incidence and the Excess Burden of Taxation Prof George Alogoskoufis

2 Determining Tax Incidence The goal of determining tax incidence is to assess who ultimately bears the burden of paying a tax. To determine the four rules of tax incidence we shall assume a tax of a fixed amount on a specific commodity, such as an excise tax. An alternative form of taxation is an ad valorem tax, which is a fixed percentage of the sales price. The main difference of fixed and ad valorem taxes is that the latter shift demand and supply curves proportionately. 2

3 Rule 1: The Statutory Burden of the Tax does not Describe Who Pays the Tax Tax laws do not accurately describe who pays the tax. The statutory incidence of a tax is determined by who pays the tax to the government. Who is ultimately liable for the tax. This could be either producers (firms) or consumers (households). The economic incidence of a tax measures who actually bears the burden of the tax. It is the difference in economic resources of producers and consumers before and after the tax is imposed. The statutory incidence is different than the economic incidence. 3

4 Tax Incidence: An Excise Tax on Producers 4

5 Tax Incidence: An Excise Tax on Consumers 5

6 Rule 2: The Side of the Market on Which the Tax is Imposed is Irrelevant for the Economic Incidence of a Tax Tax incidence is identical whether a tax is imposed on producers or consumers. Distinction between gross price and after tax price. Gross price is the price paid or received by the party not paying the tax to the government. It is the same as the market price. After tax, or net, price is the price paid or received by the party paying the tax to the government. It is the the market price adjusted for the tax. If producers pay the tax, it is the market price minus the tax. If consumers pay the tax, it is the market price plus the tax. 6

7 Rule 3: The Incidence of Taxes Depends on the Elasticities of Demand and Supply The incidence of taxation on producers and consumers depends on the elasticities of demand and supply of consumers and producers. The side of the market with the more inelastic response bears a larger share of the burden of taxation. In the extreme case of a perfectly inelastic demand or supply curve, the relevant side of the market pays all the tax. In the extreme case of a perfectly elastic demand or supply curve, the relevant side of the market pays no tax at all. The burden of the tax shifts to the other side of the market. In intermediate cases, demand and supply elasticities determine the distribution of the tax burden. 7

8 Tax Incidence with Perfectly Inelastic Demand 8

9 Tax Incidence with Perfectly Elastic Demand

10 Tax Incidence with Perfectly Inelastic Supply 10

11 Tax Incidence with Perfectly Elastic Supply 11

12 Rule 4: Taxes imply an Excess Burden or Deadweight Loss Taxes imply inefficiencies when either the demand or the supply are not perfectly inelastic. The loss of consumer and producer surplus implied by a tax exceeds the value of the government revenue. This is called the excess burden or the deadweight loss of taxation. Thus, in general, taxation implies extra inefficiencies in a market economy, as it is distortionary. Very few non distortionary taxes exist, if at all. If either the demand curve or the supply curve are perfectly inelastic, then there is no excess burden. The burden of the tax is borne solely by either producers or consumers, depending on whether it is supply or demand that is perfectly inelastic. In general, the higher the elasticities of demand (and supply), the higher the excess burden of taxes. 12

13 The Excess Burden of Taxation 13

14 No Excess Burden with Perfectly Inelastic Supply 14

15 No Excess Burden with Perfectly Inelastic Demand 15

16 Excess Burden and the Elasticity of Demand 16

17 Optimal Ramsey Taxation The government should be setting taxes in such a way as to make the ratio of the marginal deadweight loss to marginal tax revenue equal across commodities. This ratio should be equal to the marginal value of government expenditure. In general, goods in more inelastic demand (or supply) should be taxed more heavily according to the Ramsey rule. However, the Ramsey rule must be modified to allow for distributional considerations. 17