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Key Points
1. The economic incidence of a tax is often different from the legal incidence. If the legal taxpayer
can reduce or avoid the tax burden by substituting lower-taxed or untaxed activities for higher-
taxed activities, then the burden will be partially or fully shifted from the legal taxpayer to other
individuals.
2. Suppliers bear a smaller share of a tax when supply is more elastic and demand is more inelastic.
Consumers bear a smaller share of a tax when demand is more elastic and supply is more
inelastic.
3. Any tax that changes the relative price of a good, service, or activity has a substitution effect. The
substitution effect causes taxpayers to substitute less-preferred lower-taxed goods, services, or
activities for the more-preferred but higher-taxed good, service, or activity. The substitution
effect imposes an excess burden on taxpayers in addition to the direct burden imposed by
payment of the tax.
4. The excess burden of a tax is larger the more elastic is the demand and the more elastic is the
supply. Excess burden increases exponentially as the tax increases.
5. Taxes are classified as progressive, proportional, or regressive based on how the average tax rate
(not tax liability) changes when the tax base or income changes. Even with a regressive tax,
higher income individuals may pay more dollars of tax.
Synopsis
There are two major economic principles in the analysis of taxation: the incidence of a tax and the
effect of a tax on economic efficiency (referred to as the excess burden or welfare cost of the tax).
These principles are applicable to all taxes.
We begin by distinguishing two concepts of incidence. Legal incidence refers to the individual or
group that is legally responsible for paying the tax to the government. Economic incidence refers to
the individual or group that bears the real burden of the tax, the individual or group whose real
income is reduced by the tax. If the burden of the tax is shifted, the economic incidence is different
from the legal incidence.
Next, we show that economic incidence depends on substitutability as reflected in the elasticities of
demand and supply. Individuals or groups that have fewer substitution possibilities also have more
inelastic demands or supplies. Individuals with more inelastic demands or supplies bear the larger
share of the tax. Therefore, no matter where the legal incidence is imposed, consumers bear a smaller
share of the tax when demand is more elastic and supply is more inelastic. Suppliers bear a smaller
share of the tax when supply is more elastic and demand is more inelastic.
Any tax that changes the relative price of an economic good, service, or activity has a substitution
effect. The substitution effect arises because taxpayers substitute less-preferred lower-taxed goods,
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services, or activities for the more-preferred but higher-taxed good, service, or activity. We show that
this substitution causes a loss in consumer surplus and producer surplus. The loss in surplus is greater
than the tax revenue collected. This is the excess burden of a tax. The greater the substitution
possibilities, the larger is the excess burden. Therefore, excess burden is greater the more elastic the
demand and the more elastic the supply. Excess burden also increases exponentially as the tax is
increased.
Then, we introduce the concepts of average and marginal tax rates and the concepts of progressivity,
proportionality, and regressivity. Finally, there are some clarifying comments about applied incidence
analysis.
Lecture Notes
I. Tax incidence
A. Definition: The individual or group of individuals on whom the burden of a tax rests
bears the incidence of the tax.
1. Legal incidence: The individual or group of individuals that has the legal
responsibility for paying the tax to the government bears the legal incidence
of the tax.
1. The individuals who bear the legal incidence may be different from those
who bear the economic incidence.
2. When the economic incidence differs from the legal incidence, we say that
the burden of the tax has been "shifted".
1. General proposition: For any fixed elasticity of demand, the more inelastic is
the supply the greater the share of the tax borne by suppliers and the smaller
the share borne by consumers.
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Price
Demand Supply
$1.50
Tax
$1.00
Quantity
5000
(3) Consumers bear none of the tax burden because the price of
gasoline doesn’t change. The burden of the tax is not shifted.
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ECO 4554: Economics of State and Local Government
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Price
Demand
Quantity
2000 5000
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ECO 4554: Economics of State and Local Government
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1. General proposition: For any fixed elasticity of supply, the more inelastic is
the demand the greater the share of the tax borne by consumers and the
smaller the share borne by suppliers.
2. Examples
Price
Supply with tax
Supply without tax
$1.50 Demand
Tax
$1.00
Quantity
2500 5000
(3) Consumers bear none of the tax burden because the price of
gasoline doesn’t change. The burden of the tax is not shifted.
Price
Demand Supply with tax
Supply without tax
$2.00
Tax
$1.50
Quantity
5000
(2) The economic incidence and the legal incidence are entirely
different. The entire burden of the tax is shifted from
suppliers to consumers through higher prices. The entire
economic incidence rests on consumers. Each consumer's
real income is reduced in proportion to her/his pre-tax
expenditure on gasoline.
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a. If consumers have good substitutes for the taxed good, demand will
be relatively elastic. Consumers can then avoid the tax by
substituting other non-taxed or lower-taxed goods for it.
2. In summary, consumers bear a smaller share of the tax when demand is more
elastic and supply is more inelastic. Suppliers bear a smaller share of the tax
when supply is more elastic and demand is more inelastic.
1. A tax increases the price of the taxed good or activity relative to the prices of
untaxed or lower-taxed goods and activities. The increase in the relative price
affects the taxpayer in two ways.
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b. Substitution (or price) effect: The tax creates an incentive for the
taxpayer to substitute less-preferred but untaxed or lower-taxed
goods for the more-preferred taxed good. The loss in consumer
utility from this substitution is the excess burden (or welfare cost) of
the tax.
B. Example
1. Suppose without the tax the equilibrium price is $1.50 per gallon and the
equilibrium quantity is 5000 gallons. Then, a tax of $6.00 per gallon is
imposed. Supply decreases (the supply curve shifts up by the amount of the
tax). The equilibrium price rises to $7.50 per gallon. Equilibrium quantity
decreases to zero.
Price
Demand
Quantity
5000
2. Because consumers simply stop purchasing gasoline when the tax is $6.00
per gallon, the tax raises no revenue. Because taxpayers pay no tax, there is
no loss of purchasing power or real income. The income effect is zero, so the
tax imposes no direct burden.
3. Even though consumers pay no tax and lose no real income, they are still
worse off with the tax than without the tax. They substitute other less-
preferred but lower-taxed goods for gasoline, but the other goods do not
provide as much utility or satisfaction as the gasoline. Because they are no
longer consuming gasoline, they lose the consumer surplus they would obtain
from gasoline consumption without the tax. The loss in consumer surplus is
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the excess burden of the tax. It is a burden in excess of, or over and above,
the loss in purchasing power or real income from paying the tax.
C. Definition: The excess burden of a tax is the loss of social (consumer and producer)
surplus (measured in dollars) in excess of the tax revenue collected by the
government. See PowerPoint Slides Figure 8-6.
1. The loss in taxpayers’ utility or satisfaction is greater than the amount of the
tax. First, taxpayers lose purchasing power (and therefore utility or
satisfaction or real income) equal to the amount of the tax. This is the direct
burden of the tax. But taxpayers also lose additional utility or satisfaction or
real income in excess of the tax because of the substitution effect. This is the
excess burden of the tax.
4. Example
a. Without a tax, the equilibrium price is $1.50 per gallon and the
equilibrium quantity is 5000 gallons. The tax is $0.50 per gallon.
b. The tax increases cost so supply decreases (the supply curve shifts up
by the amount of the tax). Equilibrium price rises to $1.80.
Equilibrium quantity decreases to 4000 gallons. The social surplus is
reduced by the sum of the blue area and the purple area.
Price
Supply with tax
Demand
Supply without tax
$1.80
Tax
$1.50
$1.30
Quantity
4000 5000
c. The blue area is equal to the tax revenue. It is the direct burden of the
tax. Taxpayers (consumers and suppliers) lose purchasing power or
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real income equal to the direct burden. However, when the tax
revenues are spent by the government, those who benefit from the
expenditure are better off by this amount. Therefore, this part of the
taxpayers’ loss is just offset by a gain to the beneficiaries of the
government expenditure. There is no net loss to society from the
direct burden of the tax.
D. Efficient taxes
2. Taxpayers would be better off, but the tax revenue (the direct burden) would
be the same so the beneficiaries of the government expenditure would be
unaffected. Therefore, taxes that impose an excess burden are inefficient
because there exists an alternative tax (one without an excess burden) that
makes taxpayers better off without making anyone worse off.
2. Example
2. Example
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ECO 4554: Economics of State and Local Government
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2. Example
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c. If, instead, a tax of $1.00 per gallon (equal to 66.7% of the initial
price) is imposed, equilibrium price rises by the amount of the tax to
$2.50 per gallon and equilibrium quantity decreases from 5000
gallons to 2000 gallons. The welfare cost or excess burden is shown
by the sum of the blue area and the purple area.
d. The higher tax is double the lower tax ($1.00 per gallon versus $0.50
per gallon), but the excess burden of the higher tax is $1500, four
times the $375 excess burden of the lower tax. The excess burden
increases exponentially, not proportionately, with the tax rate.
A. Two different tax rate concepts are used in the economic analysis of taxation, the
average tax rate (ATR) and the marginal tax rate (MTR).
1. The average tax rate indicates the individual’s total tax liability as a
percentage of an appropriate index or benchmark:
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2. The marginal tax rate indicates the percentage change in your tax liability
when the benchmark changes:
a. Tax base as benchmark: Suppose next year you use 660 gallons. At
$1.50 per gallon, next year’s gasoline expenditure is $990. Next
year’s tax liability is $330. The change in your tax liability is $30;
the change in your gasoline expenditure is $90. The marginal tax rate
using the tax base as the benchmark is 33.3%.
3. The average tax rate is relevant for equity issues while the marginal tax rate
is relevant for efficiency issues.
2. Definitions
3. Examples: Suppose income is the benchmark. The table shows three different
examples of how tax liability might change as income increases.
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a. Total tax liability increases when income increases under each tax
system, but
• with the progressive tax, the average tax rate also increases.
b. Even with a regressive tax, higher income individuals may pay more
tax. The classification of the tax as progressive, proportional, or
regressive is determined by the behavior of the average tax rate, not
the behavior of total tax liability.
4. If a tax is progressive, the marginal tax rate is greater than the average tax
rate (MTR>ATR). If a tax is proportional, the marginal tax rate is equal to the
average tax rate (MTR=ATR). If a tax is regressive, the marginal tax rate is
less than the average tax rate (MTR<ATR). This is an application of the usual
rule concerning the relationship between averages and marginals.
5. A tax can be proportional using the tax base as the benchmark but
progressive or regressive using income as the benchmark. Or a tax can be
regressive or progressive using the tax base as the benchmark, but
proportional using income as the benchmark.
A. Firms purchase the services of resource inputs (labor services, land services, and
capital services) from the owners of these resource inputs. The owners receive
income from the sale of their labor, land, and capital services. Firms use the services
of the resource inputs to produce goods and services that are demanded by consumers
and for which the consumers make expenditures.
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Resource Output
Inputs
Landowners Land
Goods
Workers Labor Firms and Consumers
Services
Capitalists Capital
Demand Goods
Supply Resources Demand Resources
and Services
Receive Income Supply Goods and
Consumption
Services
Expenditures
1. The economic effects of taxes are transmitted through price changes. A tax
may change the prices of goods and services and also the prices paid to the
resource inputs that produce them.
3. The same individual may be both a consumer and a resource supplier. This is
a very important point to understanding incidence analysis. Any individual’s
share of the tax depends both on how much of her/his income is spent on
goods whose prices have changed and how much of her/his income is
received from supplying resources whose prices have changed.
1. The first step is to determine how much of a tax is borne by consumers and
how much is borne by suppliers, and further, how much of the supplier tax is
borne by particular factors of production (labor, capital, land). In other
words, we first determine the effect of the tax on the functional distribution
of income.
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3. Example: Suppose we determine that a gasoline tax equal to 10% of the pre-
tax price increases the price by 4%.
d. We can then determine the average effective tax rate for individuals
with incomes between $30,000 and $40,000 by dividing their
average tax burden by their average income. If this average tax rate
decreases as we move up the income distribution, the gasoline tax is
regressive.
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