1. TAXATION AND INCOME DISTRIBUTION
Chapter 14

2. Vocabulary Statutory Incidence Economic Incidence Tax Shifting
Statutory Incidence
Economic Incidence
Tax Shifting
Partial Equilibrium Models
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
Partial Equilibrium Models- look at a single market, appropriate when market for commodity is small relative to economy

3. 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

4. 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)

5. Measuring How Progressive a Tax System Is

6. Measuring How Progressive a Tax System is – A Numerical Example

7. Partial Equilibrium Models
Models that study only one market and ignore possible spillover effects on other markets
Economic incidence depends on:
Elasticities of Supply and Demand
Tax Salience: the extent to which a tax rate is made prominent to a taxpayer
Economic incidence does not depend on whether it is levied on Consumers or Producers.

8. Unit Tax on Commodities
Price S1
Before Tax
After Tax
Consumers Pay
Suppliers Receive S0
$1.20
$1.40
Unit Tax on Commodities
Consumer Pays $1.20
Producer receives $1.20
Tax on Consumers of $.40 per gallon
D curve shifts down – D curve perceived by supplier-amount of money the supplier will receive
Tax wedge – tax induced spread between price paid by consumer and price received by producer
Tax on Producers of $.40/gal
Draw new supply curve
Consumer Pays $1.40
Producer receives $1.40
Economic incidence independent of statutory incidence
$1.20
$1.00 D0 D1
Quantity

9. Perfectly Inelastic SupplySX
Price
Perfectly Inelastic Supply S DX
DX’
Quantity

10. Perfectly Elastic Supply
Price S
Perfectly Elastic Supply SX DX
DX’
Quantity

11. Ad Valorem Taxes Sf Price per Pound of food Pr P0 Pm Df Df’ Qr Q0 Qm
Pounds of food per year

12. Taxes on Factors Statutory vs. Economic Incidence
The Payroll Tax
Tax on labor that finances Social Security
Tax on Capital in a Global Economy

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

14. Commodity Taxation without Competition
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
Oligopoly
Can result in higher or lower profits

15. Economic Profits after unit tax
Monopoly $
Economic Profits
MXX c a P0
ATCX
Economic Profits after unit tax Pn i f d h g b
ATC0 DX
MRX
DX’
X per year X1 X0
MRX’

16. Profits Taxes Economic profit Perfect competition Monopoly
Measuring economic profit

17. 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

18. 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

19. 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: McLure [1971].
14-19

20. 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

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

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

23. An Applied Incidence Study
Average Federal Tax Rates and Share of Federal Taxes
by Income Quintile (2009)
Income Category
Average Federal Tax Rate
Share of Federal Taxes
Lowest Quintile
1.0%
0.3%
Second Quintile
6.8%
3.8%
Third Quintile
11.1%
9.4%
Fourth Quintile
15.1%
18.3%
Highest Quintile
23.2%
67.9%
All Quintiles
17.4%
100.0%
Top 1%
28.9%
22.3%
Source: Congressional Budget Office (2012a)

24. Chapter 14 Summary
Who bears the burden of a tax? It depends on price changes, which, in turn, depend on:
Time frame
Disposition of tax revenue
Market structure
Elasticities of supply and demand
Mobility of factors of production
Tax salience
Partial equilibrium incidence and general equilibrium incidence analyses are used to determine burdens of unit and ad-valorem taxes