1. TAXATION AND INCOME DISTRIBUTION
Chapter 14
©2016 by McGraw-Hill Education Limited.

2. Learning Objectives
Distinguish between the statutory incidence and the economic incidence of tax.
Illustrate the difference between a marginal tax rate and an average tax rate.
Describe two ways of measuring tax progressiveness.
Relate the incidence of tax to the elasticities of supply and demand.

3. Learning Objectives (cont)
Explain why a tax on economic profits cannot be shifted onto consumers.
Give examples of tax equivalence relations in general equilibrium models.
Analyze the output effect and the substitution effect of a partial factor tax.

4. Vocabulary Statutory Incidence Economic Incidence Tax Shifting LO1
Statutory Incidence
Economic Incidence
Tax Shifting
Tax Analysis – use of economic theory to analyze impact of taxes
Equity and Efficiency – how do taxes affect the distribution of income, how do taxes affect economic efficiency
Statutory Incidence - who is legally responsible for tax (who writes the check)
Economic Incidence – whose purchasing power is reduced by the tax
Tax Shifting – extent that statutory and economic incidence differ

5. 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

6. Tax Progressiveness Can Be Measured in Several Ways
LO2, LO3
Tax Progressiveness Can Be Measured in Several Ways
Average tax rate versus marginal tax rate
Proportional tax system
Progressive tax system
Regressive tax system
Tax Liabilities under a hypothetical tax system
Income
Tax Liability
Average Tax Rate
Marginal Tax Rate
$2,000
-$200
-0.10
0.2
3,000
5,000
400
0.08
10,000
1,400
0.14
30,000
5,400
0.18
Tax scheme depicted – Tax = 0.20*(Income - $3,000)
Table 14.1

7. Measuring the Degree of Progressive of a Tax System

8. Partial Equilibrium Models
Models that look only at the market in which the tax is imposed and ignore the ramifications in other markets

9. Unit Taxes on Commodities
Economic incidence does not depend on whether it is levied on consumers or producers
Economic incidence depends on elasticities of supply and demand

10. Unit Taxes on Commodities Price and Quantity Before Taxation
Price per litre of wine a Pa Sw u b P0 m Pc u n Dw Qa Q0 Qc
Litres of wine per year
Figure 14.1

11. LO4
Unit Taxes on Commodities Incidence of a Unit Tax Imposed on the Demand Side
Price per litre of wine Sw
Tax wedge = fh
Tax Revenue = kfhn
Price paid by consumers k f Pg g m
Original price P0 Pn n
Price received by producers h u Dw
D’w Q1 Q0
Litres of wine per year
Figure 14.2

12. LO4
Unit Taxes on Commodities Incidence of a Unit Tax Imposed on the Supply Side
Price per litre of wine
S’w j Sw u
Price paid by consumers
P’g Pi
Original price P0
P’n
Price received by producers Dw
Q’1 Q0 Q1
Litres of wine per year
Figure 14.3

13. LO4
Unit Taxes on Commodities Tax Incidence when Supply is Perfectly Inelastic SX
Price per litre of X
Price received by suppliers falls by the full amount of the tax
Pg=P0 u Pn Dx
D’x
X per year
Figure 14.4

14. LO4
Unit Taxes on Commodities Tax Incidence when Supply is Perfectly Elastic
Price per litre of Z
Price paid by consumers increases by the full amount of the tax Pg u
Pn=P0 Sz Dz
D’z Z1 Z0
Z per year
Figure 14.5

15. Ad Valorem Taxes Sc Price per unit of clothing r Pr s P0 m Pm n Dc QrQm
Units of clothing
Figure 14.6

16. Ad Valorem Taxes Incidence of an Ad Valorem Tax
S’c Sc
Price per unit of clothing Pg P0 Pn Dc
D’c Q1 Q0
Units of clothing
Figure 14.7

17. Taxes on Factors The payroll Tax Capital taxation in a global economy
Tax on labor used to finance the Canada Pension Plan (CPP)
Capital taxation in a global economy

18. The Payroll Tax LO4 SL Wage rate per hour Pr wg = w0 wn DL DL’ L0 = L1
Hours per year
Figure 14.8

19. Commodity Taxation with Monopoly
Despite market power a monopolist is generally made worse off
QD does down
Price paid by consumers goes up
Price received by the monopolist goes down
Profits go down

20. Equilibrium of a Monopolist$
Economic Profits
MXX c a P0
ATCX d b
ATC0 DX
MRX
X per year X0
Figure 14.9

21. Imposition of a Unit Tax on a Monopolist$
Economic Profits
MXX c a P0
ATCX
Economic Profits after unit tax Pn i f d h g b
ATC0 DX
DX’
MRX
X per year X1 X0
MRX’
Figure 14.10

22. Taxes on Profits Economic profit Perfect competition Monopoly
LO5
Taxes on Profits
Economic profit
Perfect competition
Monopoly
Measuring economic profit

23. 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: A stream of tax liabilities becomes incorporated into the price of an asset

24. General Equilibrium Models
Show how various markets are interrelated
Consider a 2-commodity, 2-factor economy resulting in the following 9 possible ad valorem taxes
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
t = a general income tax

25. Tax Equivalence Relations
LO6
Tax Equivalence Relations
Partial factor tax: tax levied on an input in only some of its uses.
tKF, tLF, tKM, tLM
Tax Equivalence: any two sets of taxes that generate the same changes in relative prices.
tKF
and
tLF
are equivalent to tF
tKM
tLM tM
are
equivalent to tK tL t
Source: Charles E. McLure, Jr., “The Theory of Tax Incidence with Imperfect Factor Mobility,” Finanzarchiv 30 (1971): 29.
Table 14.2
14-25

26. 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

27. Analysis of Various Taxes
LO7
Analysis of Various Taxes
Commodity tax (tF)
Income tax (t)
General tax on labor (tL)
Partial factor tax (tKM)
Output effect
Factor substitution effect

28. Incidence of a Partial Factor Tax (tKM) in a General Equilibrium Model
Figure 14.11

29. Some Qualifications Differences in individuals’ tastes
Immobile factors
Variable factor supplies

30. Applied Incidence Studies Average Tax Rate, Total Taxes, by Broad Income, Canada, 1990 to 2005
Figure 14.12

31. Applied Incidence Studies Decile Cut-offs, 1990 and 2005 (in constant 2010 dollars)
Table 14.3

32. Applied Incidence Studies Average Tax Rate, by Revenue Source, Broad Income, Standard Case, Canada, 2005
Figure 14.13

33. Applied Incidence Studies Average Tax Rate, by Revenue Source, Broad Income, Standard Case, Canada, 2005
Figure 14.14

34. Chapter 14 Summary
Statutory incidence refers to the legal liability for a tax, while economic incidence shows the actual sacrifice of income due to the tax.
Economic incidence is determined by the way price changes when a tax is imposed; the incidence of a tax ultimately falls on individuals via both their sources and uses of income.
In partial equilibrium competitive models, tax incidence depends on the elasticities of supply and demand.
Due to capitalization, the burden of taxes may be borne by current owners of an inelastically supplied durable commodity, such as land.

35. Chapter 14 Summary (cont)
General equilibrium incidence analysis is often conducted using a two-sector, two-factor model.
Taxing a single factor in its use only in a particular sector changes relative factor prices and the distribution of income. The particular outcome depends on factor intensities, ease of substitution of products, mobility of factors, and elasticities of demand for outputs.
Applied incidence studies indicate the Canadian system is progressive up to the middle of the income distribution, then modestly regressive thereafter.