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ECO 4554

Economics of State and Local Government


Lecture Notes

PRINCIPLES OF TAX ANALYSIS

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.

B. Two concepts of incidence

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.

2. Economic incidence: The individual or group of individuals whose real


income (or welfare or utility) is reduced by the tax bears the economic
incidence.

C. Economic incidence is independent of legal incidence

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".

3. The effects of a tax on the allocation of resources and on the distribution of


income depend on the economic incidence, not the legal incidence.

D. Incidence analysis is essentially hypothetical. It compares the distribution of real


income (or utility) under existing policy with the distribution that would exist under a
different policy, or it compares the distribution of real income under two different
policies, neither of which currently exists.

II. Incidence depends on elasticities

A. Incidence and the elasticity of supply

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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2. Examples: Suppose an excise tax of $0.50 per gallon is imposed on gasoline.


Without the tax, the equilibrium price of gasoline would be $1.50 per gallon
and the equilibrium quantity would be 5000 gallons.

a. Perfectly inelastic supply (vertical supply curve) See PowerPoint


Slides Figure 8-1.

(1) Neither equilibrium price and nor equilibrium quantity are


changed by the tax. The equilibrium price is $1.50 and the
equilibrium quantity is 5000 gallons with the tax or without
the tax.

(2) Economic incidence and legal incidence are the same.


Because the equilibrium price is unchanged, the net price
received by the suppliers decreases to $1.00 per gallon.
Suppliers bear the full burden of the tax. Their net revenue is
reduced by exactly the amount of the tax. The tax burden is
distributed among all the sellers in proportion to their sales
revenues.

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.

b. Perfectly elastic supply (horizontal supply curve reflecting constant


marginal costs) See PowerPoint Slides Figure 8-2.

(1) The tax increases suppliers’ costs by $0.50, the amount of


the tax. Supply decreases (the supply curve rises by the
amount of the tax). Equilibrium price rises from $1.50 to
$2.00, and equilibrium quantity decreases from 5000 gallons
to 2000 gallons.

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(2) Economic incidence and legal incidence are entirely


different. The full tax burden is shifted from suppliers to
consumers through higher prices. Each consumer's real
income is reduced in proportion to her/his pre-tax
expenditure on gasoline.

Price

Demand

$2.00 Supply with tax


Tax
$1.50 Supply without tax

Quantity
2000 5000

c. Intermediate case (positively-sloped supply curve)

(1) Supply decreases (the supply curve shifts up by $0.50, the


full amount of the tax). Price increases.

(2) The higher price provides an incentive for consumers to


reduce their purchases of gasoline. The equilibrium price
with the tax is higher than the price without the tax, but the
difference is less than the full amount of the tax. Equilibrium
quantity decreases.

(3) Consumers bear part of the tax burden in higher gasoline


prices. Suppliers also bear part of the tax burden in lower
sales revenues.

(4) The amount of the tax that can be shifted to consumers


depends on the elasticity of supply. If supply is more
inelastic (closer to vertical), suppliers bear more of the tax. If
it is more elastic (closer to horizontal), consumers bear more
of the tax.

B. Incidence and the elasticity of demand

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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

a. Perfectly elastic demand (horizontal demand curve) See PowerPoint


Slides Figure 8-3.

(1) The tax increases suppliers’ costs by $0.50, the amount of


the tax. Supply decreases (the supply curve shifts up or left
by the amount of the tax). Equilibrium price is unchanged
but equilibrium quantity decreases from 5000 gallons to
2500 gallons.

Price
Supply with tax
Supply without tax

$1.50 Demand
Tax
$1.00

Quantity
2500 5000

(2) Economic incidence and legal incidence are the same.


Because the equilibrium price is unchanged, the net price
received by the suppliers decreases to $1.00 per gallon.
Suppliers bear the full burden of the tax. Their net revenue is
reduced by exactly the amount of the tax. The tax burden is
distributed among all the sellers in proportion to their sales
revenues.

(3) Consumers bear none of the tax burden because the price of
gasoline doesn’t change. The burden of the tax is not shifted.

b. Perfectly inelastic demand (vertical demand curve) See PowerPoint


Slides Figure 8-4.

(1) The tax increases suppliers’ costs by $0.50, exactly the


amount of the tax. Supply decreases (the supply curve shifts
up by the amount of the tax). When supply decreases,
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equilibrium price rises from $1.50 to $2.00. Equilibrium


quantity is unchanged at 5000.

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.

c. Intermediate case (negatively-sloped demand curve) See


PowerPoint Slides Figure 8-5.

(1) Supply decreases (the supply curve shifts up by the amount


of the tax). Price increases.

(2) The higher price provides an incentive for consumers to


reduce their purchases of gasoline. Therefore, equilibrium
price rises by $0.40 (from $1.50 to $1.90), which is less than
the full amount of the tax. Equilibrium quantity decreases to
4900.

(3) Consumers bear part of the tax burden in higher gasoline


prices (from $1.50 to $1.90 per gallon). Suppliers also bear
part of the tax burden in lower revenues per gallon (from
$1.50 to $1.40 per gallon).

(4) The amount of the tax that can be shifted to consumers


depends on the elasticity of demand. If demand is relatively
more elastic (closer to horizontal), suppliers bear more of the

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tax. If demand is more inelastic (closer to vertical),


consumers bear more of the tax.

C. Incidence, elasticity, and substitutability

1. Elasticity reflects the possibility of substitution. The greater the possibility of


substitution, the greater is the elasticity.

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.

b. Similarly, if suppliers have good substitute uses for their resources,


supply will be relatively elastic. Suppliers can avoid the tax by
producing less of the taxed good and shifting their resources to other
uses.

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.

III. Excess burden

A. Income effect and substitution effect

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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ECO 4554: Economics of State and Local Government
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a. Income effect: The tax reduces the taxpayer's purchasing power or


real income. It takes resources away from the taxpayer and transfers
them to the government. This is often referred to as the direct
burden of the tax.

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.

2. Any tax that imposes an excess burden is economically inefficient. The


inefficiency of the tax is a result of the substitution effect. All current taxes
impose an excess burden so all current taxes are inefficient.

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

$7.50 Supply with tax

Demand

$1.50 Supply without tax

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.

2. The excess burden reflects an inefficient allocation of resources. Resources


are shifted from production of the more valuable taxed good to less valuable
untaxed or lower taxed goods.

3. The concept of welfare cost provides a dollar measure of this inefficiency or


excess burden.

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. The purple area is a loss in consumer and producer surplus in excess


of the tax revenue. It is a loss to consumers and suppliers that is not
offset by a gain to anyone else. Therefore, it is a net loss of real
income (or utility or satisfaction) to society. This is the excess
burden of the tax.

D. Efficient taxes

1. If the same revenue could be collected without creating incentives for


consumers and producers to substitute less-preferred for more-preferred
goods, the excess burden of a tax could be eliminated. To avoid creating
substitution incentives, the same tax must be imposed on every good, service,
or activity.

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.

3. A tax with no substitution effects is called a lump-sum tax. With a lump-sum


tax, an individual’s tax liability is independent of any economic decisions or
choices or behavior. A lump-sum tax is the only truly efficient tax.

4. Problem: There are no lump-sum taxes. A hypothetical lump-sum tax is often


used as a benchmark against which to measure the welfare cost or excess
burden of actual taxes, but no existing taxes are lump-sum taxes. In fact,
lump-sum taxes are usually considered to be inequitable even though they are
efficient.

IV. Principles of excess burden analysis

A. Excess burden and the elasticity of demand

1. General proposition: For a fixed elasticity of supply, excess burden is larger


the more elastic is demand. See PowerPoint Slides Figure 8-7.

2. Example

a. The excise tax on gasoline increases suppliers’ costs so supply


decreases (the supply curve shifts up by the amount of the tax). With
perfectly elastic supply, the entire economic incidence of the tax is
shifted forward to consumers. Equilibrium price increases by the full
amount of the tax.
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b. Elastic demand: Suppose demand is relatively elastic. When price


increases, equilibrium quantity decreases from 5000 gallons to 2000
gallons. The substitution effect is large, creating a large excess
burden shown by the blue triangle.

c. Inelastic demand: Suppose demand is relatively inelastic. Now, when


price increases, equilibrium quantity only decreases from 5000
gallons to 4000 gallons. The substitution effect is smaller and the
excess burden, shown by the purple triangle, is also smaller.

B. Excess burden and the elasticity of supply

1. General proposition: For a fixed elasticity of demand, the excess burden is


larger the more elastic is supply. See PowerPoint Slides Figure 8-8.

2. Example

a. With perfectly elastic demand, consumers are unwilling to pay a


higher price for gasoline. Equilibrium price is unchanged by the tax.
Instead, the net price received by sellers decreases to $1.00 per
gallon so that sellers bear the entire economic incidence of the tax.

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b. Elastic supply: Suppose supply is relatively elastic. When price


increases, equilibrium quantity decreases from 5000 gallons to 2000
gallons. The substitution effect is large, creating a large excess
burden shown by the blue triangle.

c. Inelastic supply: Suppose supply is relatively inelastic. When price


increases, equilibrium quantity decreases from 5000 gallons to 4000
gallons. The substitution effect is smaller and the excess burden,
shown by the purple triangle, is also smaller.

C. Excess burden and the tax rate

1. General proposition: The excess burden of a tax increases exponentially as


the tax rate increases. See PowerPoint Slides Figure 8-9.

2. Example

a. Assume that supply is perfectly elastic so that the entire economic


incidence of the tax is shifted forward to consumers. (This
assumption is made only for convenience. The result is valid
regardless of the elasticities of demand and supply.)

b. If a tax of $0.50 per gallon (equal to 33.3% of the initial price) is


imposed, equilibrium price rises by the amount of the tax to $2.00
per gallon. Equilibrium quantity decreases from 5000 gallons to
3500 gallons. The welfare cost or excess burden is shown by the blue
area.

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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.

V. Average and marginal tax rates

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:

Average tax rate (ATR) = Total tax liability ÷ Benchmark

The benchmark is usually either the tax base or income.

a. Tax base as benchmark: Suppose the price of gasoline is $1.50 per


gallon and your annual consumption of gasoline is 600 gallons. Your
total annual expenditure on gasoline is $900. If the excise tax on
gasoline is $0.50 per gallon (33.3% of the price), your total annual
tax liability is $300. This is 33.3% of your expenditure on gasoline
(the tax base). Using the tax base as the benchmark, the average tax
rate on gasoline is 33.3%.

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b. Income as benchmark: Suppose your annual income is $15,000.


Your $300 annual gasoline tax liability is 1% of your income. Using
income as the benchmark, the average tax rate on gasoline is 1%.

2. The marginal tax rate indicates the percentage change in your tax liability
when the benchmark changes:

Marginal tax rate (MTR) = Change in total tax liability ÷ Change in


benchmark

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%.

b. Income as benchmark: Suppose your gasoline expenditure increased


because your income increased to $16,500. Again the change in your
tax liability is $30; the change in your income is $1500. The
marginal tax rate using income as the benchmark is 2%.

3. The average tax rate is relevant for equity issues while the marginal tax rate
is relevant for efficiency issues.

a. The average tax rate is most useful in analyzing the distribution of


the tax burden among individuals or groups of taxpayers. It provides
information about the effect of the tax on the distribution of income.

b. The marginal tax rate is most useful in analyzing how individuals’


economic behavior at the margin is affected by the tax. It provides
information about the effect of the tax on resource allocation.

B. Progressivity, proportionality, and regressivity

1. Taxes are classified as progressive, proportional, or regressive based on how


the average tax rate changes when the benchmark changes.

2. Definitions

a. Progressivity: A tax is progressive if the average tax rate increases


when the benchmark increases.

b. Proportionality: A tax is proportional if the average tax rate remains


constant when the benchmark increases.

c. Regressivity: A tax is regressive if the average tax rate decreases


when the benchmark increases.

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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Income Progressive Proportional Regressive

Tax ATR MTR Tax ATR MTR Tax ATR MTR


$0 $0 ----- ----- $0 ----- ----- $0 ----- -----
$1,000 $50 5.0% 5.0% $100 10.0% 10.0% $150 15.0% 15.0%
$2,000 $150 7.5% 10.0% $200 10.0% 10.0% $250 12.5% 10.0%
$3,000 $300 10.0% 15.0% $300 10.0% 10.0% $300 10.0% 5.0%

a. Total tax liability increases when income increases under each tax
system, but

• with the progressive tax, the average tax rate also increases.

• with the proportional tax, the average tax rate remains


constant.

• with the regressive tax, the average tax rate decreases.

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.

VI. Applied incidence analysis

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

B. Taxes, prices, and incidence analysis

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.

2. Individuals, both consumers and suppliers, respond to these price changes.


Individual responses to these price changes determine both the incidence of a
tax and its welfare cost.

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.

C. Applying the theory

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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2. We generally want to know, however, how the tax affects individuals at


different income levels. That is, we want to know the effect of the tax on the
personal distribution of income. This requires that we determine the average
amount of income spent at each income level on those goods whose prices
have changed as a result of the tax and that we determine the average amount
of income received by individuals at each income level from those factors
whose prices have changed because of the tax.

3. Example: Suppose we determine that a gasoline tax equal to 10% of the pre-
tax price increases the price by 4%.

a. If price rises by 4% when a 10% tax is imposed, forty percent of the


tax is borne by consumers of gasoline in proportion to their
expenditure on gasoline and 60% is borne by suppliers in proportion
to the income they derive from the production and sale of gasoline.

b. While we may be interested in how the tax affects the functional


distribution of income (how much rests on consumers and how much
on labor, capital, and land), we are usually equally or more interested
in how the tax affects the personal distribution of income. Assume
we wish to know how the tax affects individuals with annual
incomes between $30,000 and $40,000.

c. Suppose individuals at this income level account for 5% of total


expenditures on gasoline. Then, as consumers they bear 2% (5% of
40%) of the total gasoline tax burden. Suppose that 10% of all
income earned from the production and sale of gasoline accrues to
individuals at this income level. As suppliers they bear 6% of the
total gasoline tax burden. Therefore, individuals with incomes
between $30,000 and $40,000 bear 8% of the total gasoline tax in
their capacities as both consumers and suppliers.

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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