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19
19.1 The Three Rules of Tax Incidence
19.2 Tax Incidence Extensions
19.3 General Equilibrium Tax Incidence
19.4 The Incidence of Taxation in the United States
19.5 Conclusion
The Equity Implications of Taxation: Tax Incidence
Introduction
In early 2002, with New Jersey facing a $5.3 billion budget gap, Governor James McGreevey called for changes in the state’s corporate tax system.
The outdated system based corporate tax payments on the corporation’s profits earned in the state of New Jersey, thus encouraging businesses to use accounting tricks to shift reported profits to their subsidiaries in other states.
As a result, 30 of the state’s 50 companies with the biggest payrolls each paid just $200 annually in corporate taxes.
McGreevey wanted to institute a 1% tax on corporate gross sales in New Jersey to ensure that all corporations would pay tax.
Introduction
A version of the tax reform was eventually enacted, leading one company, Federated Department Stores, to publicly announce layoffs that they attributed to the tax increase.
Governor McGreevey responded angrily, claiming that these statements were just a cover for those wealthy corporate owners who would really bear the brunt of this new tax: “All that we’re asking is that they pay their fair share: not a dollar more, not a dollar less. But when you have a CEO making $1.5 million and upwards of $14 million in stock options threatening people who are making $25,000, that’s what’s wrong.”
Introduction
The fundamental disagreement between the governor and the business community concerned who would ultimately pay this new tax.
The business community claimed workers would bear the burden, while the governor claimed the burden would be shouldered by wealthy companies and their executives.
This debate focuses on the central question of tax incidence: Who bears the burden of a tax A simple answer to this question would be that whoever sends the check to the government bears the tax. This ignores the fact that markets respond to taxes and that these responses must be taken into account to assess the ultimate burden, or incidence, of taxation.
19.1
Sources of Federal Receipts, 1960 and 2014
In 1960, 23% of federal taxes was collected from corporations, and 61.5% was collected from individuals through income and payroll taxes. Today, 15% is collected from corporations and 76% from individuals. Is this an equitable shift in the burden of taxation
19.1
The statutory burden of a tax does not describe who really bears the tax.
The side of the market on which the tax is imposed is irrelevant to the distribution of the tax burdens.
Parties with inelastic supply or demand bear taxes; parties with elastic supply or demand avoid them.
The Three Rules of Tax Incidence
19.1
Statutory incidence: The burden of a tax borne by the party that sends the check to the government.
Economic incidence: The burden of taxation measured by the change in the resources available to any economic agent as a result of taxation.
Economic incidence includes tax payments paid and any price changes caused by the tax.
Rule 1: The Statutory Burden of a Tax Does Not Describe Who Really Bears the Tax
19.1
The tax burden for consumers is:
consumer tax burden =
(post-tax price pre-tax price) + per-unit tax payments by consumers
For producers, the tax burden is
producer tax burden =
(pre-tax price post-tax price) + per-unit tax payments by producers
The Statutory Burden of a Tax Does Not Describe Who Really Bears the Tax
19.1
A tax is placed on suppliers, which shifts the supply curve upward. The market price is now 30 higher than it was before the tax was imposed.
The Statutory Burden of a Tax Does Not Describe Who Really Bears the Tax
19.1
Tax wedge: The difference between what consumers pay and what producers receive (net of tax) from a transaction.
If the consumer burden is $0.30 and the producer burden is $0.20, the tax wedge is $0.50.
Burden of the Tax on Consumers and Producers
19.1
The key insight is that the burden on producers is not the 50 tax payment they make on each gallon but some lower number because some of the tax burden is borne by consumers in the form of a higher price.
Burden of the Tax on Consumers and Producers
Q2 = 80
B
C
D
Price per
gallon (P)
Quantity in
billions of
gallons (Q)
0
A
S1
D
P1 = $1.50
Q1 = 100
(a) Tax on producers
S2
E
Tax =
$0.50
Q3 = 90
P2 = $2.00
P3 = $1.80
$1.30
Consumer
burden =
$0.30
Producer
burden =
$0.20
Rule 2: The Side of the Market on Which the Tax Is Imposed Is Irrelevant to the Distribution of the Tax Burden
19.1
Price per
gallon (P)
Quantity in
billions of
gallons (Q)
0
A
S
D1
P1 = $1.50
Q1 = 100
(b) Tax on consumers
D2
Tax =
$0.50
C
B
D
E
$1.80
P3 = $1.30
P2 = $1.00
Producer
burden =
$0.20
Consumer
burden =
$0.30
The tax burdens are identical, regardless of who bears the statutory burden.
19.1
Gross price: The price in the market.
After-tax price: The gross price minus the amount of the tax (if producers pay the tax) or plus the amount of the tax (if consumers pay the tax).
Different statutory rules produce different gross prices for the same after-tax price.
Gross Versus After-Tax Prices
19.1
The economic incidence of taxation does not depend on the statutory incidence.
It is ultimately determined by the elasticities of supply and demand, that is, how responsive the quantity supplied or demanded is to price changes.
If one side of the market is perfectly inelastic, then it bears the full burden of the tax. There is a full shifting of the tax burden to that side of the market.
Full shifting: When one party in a transaction bears all of the tax burden.
Rule 3: Parties with Inelastic Supply or Demand Bear Taxes; Parties with Elastic Supply or Demand Avoid Them
19.1
Perfectly Inelastic Demand
When demand is perfectly inelastic, producers bear none of the tax and consumers bear all of the tax.
19.1
Perfectly Elastic Demand
Producers bear all of the tax, and consumers bear none of the tax.
19.1
In general, the less elastic is demand relative to supply, the larger share of the incidence falls on demand.
Demand for goods is more elastic when there are many substitutes.
For products with an inelastic demand, the burden of the tax is borne almost entirely by the consumer.
General Case
19.1
Supply Elasticities
The same principles hold for supply as for demand elasticities; elastic factors avoid taxes, while inelastic factors bear them.
19.1
When the demand for gas is perfectly elastic, consumers bear none of the burden of taxation, yet the quantity of gas consumed fell dramatically.
Doesn’t this fall in consumption hurt consumers
If so, shouldn’t tax incidence take that into account
Perfectly inelastic demand means consumers are indifferent between the gas and other goods, so they are not hurt by the fall in gas consumption.
Reminder: Tax Incidence Is About Prices,
Not Quantities
19.2
To recap:
The statutory burden of a tax does not describe who really bears the tax.
The side of the market on which the tax is imposed is irrelevant to the distribution of tax burdens.
Parties with inelastic supply or demand bear taxes; parties with elastic supply or demand avoid them.
Tax Incidence Extensions
19.2
Tax Incidence in Factor Markets
It makes no difference that the Social Security payroll tax is levied half on workers and half on firms, rather than being levied 100% on workers or on firms. What matters for determining the burden of the Social Security tax is the total size of the tax, not how the tax is distributed across demanders and producers.
Tax incidence analysis assumes that prices can freely adjust.
But wages cannot fall below the minimum wage.
Minimum wage: Legally mandated minimum amount that workers must be paid for each hour of work.
Barriers to price adjustment change the incidence of the tax burden.
19.2
Impediments to Wage Adjustment
W2 = $8.25
Wage
(W)
Hours of
labor (H)
0
(a) Tax on workers
A
B
C’
S1
D1
H1
Wage
(W)
Hours of
labor (H)
0
A
S1
D1
$6.75
H1
(b) Tax on firms
S2
C
Tax =
$1.00
H2
H3
WM = $7.25
Firm
burden =
$0.50
Worker
burden =
$0.50
WM = $7.25
W2 = $7.75
W3 = $6.75
H2
B
C
Firm
burden =
$1.00
Tax =
$1.00
D2
Impediments to Wage Adjustment
19.2
When there are barriers to reaching the competitive market equilibrium, the side of the market on which the tax is levied can matter. The party on whom the tax is levied may matter more in input than in output markets.
19.2
Monopoly markets are an extreme case of imperfectly competitive markets.
Monopoly markets: Markets in which there is only one supplier of a good.
For price-taking firms, marginal revenue (MR) is equal to price.
Monopolists must lower the price to sell more, though, so marginal revenue falls faster than price.
Monopolist produces such that MR = MC.
Tax Incidence in Imperfectly Competitive Markets
19.2
Monopolists maximize profits by producing a good or service until the marginal cost of the next unit produced equals the marginal revenues earned on that unit. The monopolist produces Q1 and charges price P1.
Background: Equilibrium in Monopoly Markets
A’
B
Price
Quantity
0
P1
Q1
Q2
P2
D1
D2
S = MC
MR1
MR2
A
Tax
B’
Taxation in Monopoly Markets
19.2
The demand curve and marginal revenue curve shift downward. The monopolist bears some of the tax.
19.2
Even in monopoly markets, a tax on either side of the market results in the same sharing of the tax burden.
Monopolists cannot “exploit their market power” to avoid the rules of tax incidence.
Economists tend to assume that the same rules of incidence apply in more general oligopoly markets.
Oligopoly markets: Markets in which firms have some market power in setting prices, but not as much as a monopolist.
Tax Incidence in Imperfectly Competitive Markets
19.2
Tax incidence analysis typically only accounts for who pays the tax.
Balanced budget incidence: Tax incidence analysis that accounts for both the tax and the benefits it brings.
Balanced budget incidence is difficult because it is hard to determine who benefits from a given tax increase.
Balanced Budget Tax Incidence
19.3
So far, we have considered incidence in only a single market, such as the gas market.
Partial equilibrium tax incidence: Analysis that considers the impact of a tax on a market in isolation.
General equilibrium tax incidence: Analysis that considers the effects on related markets of a tax imposed on one market.
Taxes in one market affect prices in others, complicating the analysis.
General Equilibrium Tax Incidence
19.3
Effects of a Restaurant Tax:
A General Equilibrium Example
The demand for restaurants is perfectly elastic, so prices cannot increase when taxed. The supply of meals falls from S1 to S2, and the quantity of meals demanded and supplied falls to Q2. The price of a restaurant meal remains at $20, so the restaurant bears its full burden.
19.3
General Equilibrium Tax Incidence
If the burden of a tax on restaurants is borne by the restaurants, it must be borne by the factors of production used by the restaurants.
19.3
Effects of a Restaurant Tax
The meal tax acts like an increase in the restaurants’ marginal costs and shifts the supply curve inward.
Because demand is perfectly elastic, any increase in price to consumers would drive all business away.
Thus, the restaurant bears the entire burden of the tax, and consumers bear none of it.
More specifically, it is borne by the factors of production (labor and capital).
19.3
Effects of a Restaurant Tax
More specifically, it is borne by the factors of production (labor and capital).
Labor supply is likely to be very elastic because workers can always choose another job or go to work in a restaurant in a nearby town.
When the new tax goes into effect, and restaurants bear its full burden, they will reduce their demand for workers.
Each worker is worth less because the restaurant’s willingness to pay for an hour of labor falls when it is taxed on the fruits of that labor.
The labor demand curve shifts downward but because labor supply is perfectly elastic, wages do not fall, and workers bear none of this tax.
19.3
Effects of a Restaurant Tax
In the short run, having invested in a restaurant, the capital owner is stuck, unable to pull out money that has already been spent on stoves, tables, and a building.
Because the tax is borne fully by the restaurants, it reduces their demand for capital.
Capital is also worth less when the restaurant is taxed on the fruits of that capital, so the restaurant will demand capital only from those who are willing to charge a lower rate of return.
Because the supply of capital is inelastic in the short run, capital owners will bear the meals tax in the form of a lower return on their investment in the restaurant.
19.3
Factors that are inelastically demanded or supplied in both the short and long run bear taxes in the long run.
Investments are irreversible, so the supply of capital is inelastic in the short run.
Investors have many opportunities, so in the long run, elasticity of capital may be high.
Effect of Time Period on Tax Incidence:
Short Run Versus Long Run
19.3
Tax incidence depends on how broadly the tax is applied.
Taxes that are broader based are harder to avoid than taxes that are narrower, so the response of producers and consumers to the tax will be smaller and more inelastic.
A tax on local restaurants has a different incidence than a tax on all restaurants.
Effect of Tax Scope on Tax Incidence
19.3
Consider a tax on a restaurant. A higher after-tax price has three effects on other goods as well:
Income effect from lower real income.
Substitution effect toward goods that are substitutes for restaurants.
Complementary effect: Consumers may reduce their consumption of goods or services that are complements to restaurant meals.
Spillovers Between Product Markets
19.4
Excise tax varies widely across the United States.
This variation allows for quasi-experimental estimation of the impact of excise taxes on prices.
An excellent example is taxes on cigarettes:
Low of $0.17/pack in Missouri.
High of $4.35/pack in New York.
Harding et al. (2012) found the majority of tax increases, 85%, were passed onto customers in the form of higher prices, suggesting fairly inelastic demand for cigarettes.
EVIDENCE: The Incidence of Taxation:
Real-World Complications
19.4
Harding et al. (2012) also found that price increases were much lower near state borders because customers can readily cross over to nearby low-tax states to buy cigarettes.
There is a rise in cross-border shopping when taxes rise.
Much more elastic demand results—only 49% of tax increases were shifted to prices.
EVIDENCE: The Incidence of Taxation:
Real-World Complications
19.4
Kopczuk et al. (2013) were able to use a standard difference-in-difference estimation strategy to evaluate how the party paying the taxes impacts their pass-through to diesel fuel prices.
They found that a higher percentage of the tax is passed through to increased prices when taxes are paid at the wholesale level.
Retailers cheat more, and as a result pay less tax, so prices don’t rise by as much when taxes are levied at that level.
In the case of diesel fuel taxes, whether the tax is levied on the wholesaler or the retailer affects how much of the tax is passed on to the consumer.
EVIDENCE: The Incidence of Taxation:
Real-World Complications
19.4
The Congressional Budget Office and Urban Institute’s Tax Policy Center analyze tax incidence in the United States, assuming:
Income taxes are borne fully by households that pay them.
Payroll taxes are borne fully by workers.
Excise taxes are fully shifted to prices and so are borne by individuals in proportion to their consumption of the taxed item.
Corporate taxes are borne 20% by workers and 80% by owners of capital.
The Congressional Budget Office/Tax Policy Center Incidence Assumptions
19.4
Results of CBO/TPC Incidence Analysis:
Total Effective Tax Rates,1979 2014
1979 1990 2000 2011 2014
All households 22.2% 21.5% 23.0% 18.6% 19.2%
Bottom quintile 8.0 8.9 6.4 1.1 3.1
Top quintile 27.5 25.1 28.0 23.8 25.1
The total average tax rate, combining all taxes across all households, declined from 22.2% in 1979 to 20.9% in 1985, then climbed to 23% in 2000 before dropping back down to 20.7% in 2006 and further decreasing to 19.2% in 2014.
19.4
Results of CBO/TPC Incidence Analysis: Top and Bottom Quintiles’ Shares of Income and Tax Liabilities
1979 1990 2000 2012 2014
Top Quintile
Share of income 45.5% 49.5% 54.8% 56.2% 51.4%
Share of tax 56.4 57.9 66.6 70 67.3
Bottom Quintile
Share of income 4.8 4.6 3.9 3.6 4.5
Share of tax 2.1 1.9 1.1 0.3 0.7
The bottom quintile of taxpayers has always paid a very small share of taxes, and that share has fallen. The top quintile of taxpayers has always paid the majority of taxes, and that share has risen.
19.4
Tax incidence is usually evaluated by current—rather than lifetime—income.
Current tax incidence: The incidence of a tax in relation to an individual’s current resources.
Lifetime tax incidence: The incidence of a tax in relation to an individual’s lifetime resources.
Poterba (1989a) showed that gasoline and cigarette taxes are much less regressive from a lifetime than current income perspective.
Current Versus Lifetime Income Incidence
19.5
The “fairness” of any tax reform is one of the primary considerations in policy makers’ positions on tax policy.
Therefore, it is crucial for public finance economists to have a deep understanding of who really bears the burden of taxation so that we can best inform these distributional debates over the fairness of a proposed or existing tax.
Conclusion

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