Tax Incidence and Burden

1
Tax Incidence and Burden

• Professor Jane H. Leuthold
• Department of Economics
• University of Illinois at Urbana-Champaign

Econ 415 Fall 2000
2
Topics for today

• What is tax incidence and what determines the
  burden of taxation?
• Tax share and tax burden
• Tax effort index

3
Types of tax incidence

• Legal or statutory incidence
• Actual or economic incidence
• Shifting difference between economic and
  statutory incidence
• Shifted backward (to a factor of production)
• Shifted forward (to consumers)

4
Effect of a commodity tax on supply
Price
Supply after tax
Demand
Supply before tax
Price paid by buyer after tax
Tax per unit
Revenue
Price paid by buyer before tax
Perfectly competitive market
Price received by seller after tax
Q1 Q0
Market output
5
Effect of a commodity tax on demand
Price
Demand before tax
Supply
Price paid by buyer after tax
Demand after tax
Perfectly competitive market
Price paid by buyer before tax
Revenue
Price received by seller after tax
Tax per unit
Q1 Q0
Market output
6
Effect of an ad valorem tax on demand
Price
Demand before tax
Supply
Price paid by buyer after tax
Demand after unit tax
Perfectly competitive market
Revenue
Price paid by buyer before tax
Price received by seller after tax
Demand after ad valorem tax
Q1 Q0
Market output
7
Tax incidence in competitive markets

• When markets are perfectly competitive, the
  incidence of a tax is unaffected by
• Whether it is on the seller or on the buyer
• Whether it is a specific (unit) or an ad valorem
  tax
• The incidence of a tax is on the buyer the more
  inelastic demand or elastic supply

8
Incidence and elasticity
Price
S after tax
D

• In a competitive market, the burden of a
  commodity tax falls on the inelastic side of the
  market.
• Who bears the tax burden in each of these cases?

S
P1
Revenue
P0
Price
Output
S
P0 P1
Revenue
D
D after tax
Output
9
A tax on labor
Wage
Supply after tax
Demand
Supply before tax
Wage paid by employer after tax
Tax per worker
Revenue
Wage paid by employer before tax
Perfectly competitive market
Wage received by worker after tax
Q1 Q0
Labor
10
Discussion

• Who bears the burden of a tax on labor if the
  supply of labor is perfectly inelastic?
• The social security tax is imposed on employers
  and employees in equal parts. Who bears the
  burden of this tax if the labor market is
  perfectly competitive?

11
Incidence and in the long-run

• Competitive supply is generally perfectly elastic
  in the long-run.
• Who bears the burden of taxes in the long-run?

Price
D
S after tax
P1
Revenue
S
P0
Output
12
Incidence with monopoly
Price

• With linear demand and horizontal marginal cost,
  buyers and sellers share the tax burden equally.
• If this were a competitive market, who would bear
  the burden of the tax?

P1
D
S after tax
Revenue
P0
MC
MR
Output
P1 P0 ½ tax per unit
13
Incidence with monopoly
Price

• With a constant elasticity demand curve, prices
  rise by more than the tax.
• Ad valorem and specific taxes have different
  effects.

P1
Revenue
D
S after tax
P0
MC
MR
Output
14
Incidence with monopoly
Price

• A unit tax (red) yields government revenue equal
  to the red rectangle.
• An ad valorem tax (blue) results in the same
  output and price yields more government revenue.

D
MC
MR
Output
15
Summary

• Tax incidence depends on the elasticities of
  demand and supply.
• In perfectly competitive markets, tax incidence
  is independent of statutory incidence and whether
  the tax is specific or ad valorem.
• In monopoly markets, tax incidence is more
  complicated.

16
Tax share

• Tax share measures the aggregate burden of a tax
  relative to GDP.
• Tax share models can be applied across countries
  or over time.
• Control variables often include real per capita
  GDP, agriculture and mining share, and trade
  share.

17
Source WDI 2000.
18
Tax share model
19
Three Versions of the Model
What does each of these models imply about the
responsiveness of tax share to a change in per
capita income?
20
Cross-Country Estimates
Burgess and Stern (1987)
WDI 1997
21
Adding Other Variables
Tait et. al. 1972-76
WDI 1997
22
Tax Effort Index
23
US
Source WDI 2000 CD-ROM.
24
Lab 4

• T/GDP b0 b1 YP b2 TRADE b3 AG
  b4 POP e
• Calculate the ITC index for each year of your
  data
• Generate a graph of the ITC index over time
• Write a short paper describing your model and
  results. Give an economic interpretation of your
  findings.

25
Table 1 Estimated Tax Share Model for Egypt
1975-1997
  Note indicates the coefficient is
significant at the 95 confidence level.
26
Source WDI 2000 (CD-ROM)
27
Next Time
Thursday Lab 4 Measuring Tax Effort Chat
Should we add to the list of fiscal goals for
developing economies "increasing their tax effort
index?" Why or why not? Give your economic
reasoning. Next Tuesday Tax Efficiency and
Elasticity