1. Copyright © 2004 South-Western 6 Supply, Demand, and Government Policies

2. Copyright © 2004 South-Western/Thomson Learning TAXES Reasons for why governments levy taxes To raise revenue to finance government spending Managing aggregate demand (total demand in the economy) Changing the distribution of income and wealth To help correct market failure i.e. pollution

3. Copyright © 2004 South-Western/Thomson Learning TAXES Indirect Taxes Indirect taxes are levied on spending by consumers on goods and services Indirect nature because an intermediary collects the revenue on the government’s behalf i.e. retailers E.g. Value-Added Tax (VAT)

4. Copyright © 2004 South-Western/Thomson Learning How Taxes on Buyers (and Sellers) Affect Market Outcomes Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden.

5. Copyright © 2004 South-Western/Thomson Learning Elasticity and Tax Incidence Tax incidence is the manner in which the burden of a tax is shared among participants in a market.

6. Copyright © 2004 South-Western/Thomson Learning Elasticity and Tax Incidence Tax incidence is the study of who bears the burden of a tax. Taxes result in a change in market equilibrium. Buyers pay more and sellers receive less, regardless of whom the tax is levied on.

7. Copyright © 2004 South-Western/Thomson Learning Elasticity and Tax Incidence When the government imposes a tax on the sale of a good, the price of the good might rise by the full amount of the tax, by a lesser amount, or not at all.

8. Copyright © 2004 South-Western/Thomson Learning Elasticity and Tax Incidence What was the impact of tax? Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden.

9. Figure 1 A Tax on Sellers Copyright©2003 Southwestern/Thomson Learning 2.80 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Price without tax Price sellers receive Equilibrium with tax Equilibrium without tax Tax ($0.50) Price buyers pay S1S1 S2S2 Demand,D1D1 A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50). 3.00 100 $3.30 90

10. Copyright © 2004 South-Western/Thomson Learning Elasticity and Tax Incidence In what proportions is the burden of the tax divided? How do the effects of taxes on sellers compare to those levied on buyers? The answers to these questions depend on the elasticity of demand and the elasticity of supply.

11. Copyright © 2004 South-Western/Thomson Learning Elasticity and Tax Incidence In what proportions is the burden of the tax divided? If the price rises by the full amount of the tax, then the burden falls entirely on the buyer. If the price rises by a lesser amount, then the buyer and seller share the tax burden If the price doesn’t change, then the burden of the tax falls entirely on the seller.

12. Figure 3 How the Burden of a Tax Is Divided Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (a) Elastic Supply, Inelastic Demand 2.... the incidence of the tax falls more heavily on consumers... 1. When supply is more elastic than demand... Price without tax 3.... than on producers.

13. Figure 4 How the Burden of a Tax Is Divided Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (b) Inelastic Supply, Elastic Demand 3.... than on consumers. 1. When demand is more elastic than supply... Price without tax 2.... the incidence of the tax falls more heavily on producers...

14. Copyright © 2004 South-Western/Thomson Learning So, how is the burden of the tax divided? The burden of a tax falls more heavily on the side of the market that is less elastic. ELASTICITY AND TAX INCIDENCE

15. Copyright © 2004 South-Western/Thomson Learning Summary Taxes are used for many reasons including to raise revenue for public purposes. When the government levies a tax on a good, the equilibrium quantity of the good falls. A tax on a good places a wedge between the price paid by buyers and the price received by sellers.

16. Copyright © 2004 South-Western/Thomson Learning Summary The incidence of a tax refers to who bears the burden of a tax. The incidence of a tax does not depend on whether the tax is levied on buyers or sellers. The incidence of the tax depends on the price elasticities of supply and demand. The burden tends to fall on the side of the market that is less elastic.