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Who Really Pays Taxes? The Question of Tax Incidence

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Who really pays taxes? This sideshow explains why the person who is legally obligated to pay them is not always the person who bears the economic burden
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Economics for your Classroom Ed Dolan’s Econ Blog Who Really Pays Taxes? The Question of Tax Incidence June 21, 2014 Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics , from BVT Publishing.
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Page 1: Who Really Pays Taxes? The Question of Tax Incidence

Economics for your ClassroomEd Dolan’s Econ Blog

Who Really Pays Taxes?The Question of Tax Incidence

June 21, 2014

Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.

Page 2: Who Really Pays Taxes? The Question of Tax Incidence

Who Really Pays Taxes?

Governments have been collecting taxes since the dawn of history, but there is still confusion over who really pays them

The question of tax assessment tells us who bears the legal responsibility for paying a given tax.

The question of tax incidence tells us who bears the economic burden of a tax

This slideshow will explain why the answers to these two questions are not the same

June 21, 2014 Ed Dolan’s Econ Blog

Sign on an abandoned gasoline pump:29.9 cents per gallon, all taxes included

Page 3: Who Really Pays Taxes? The Question of Tax Incidence

Example 1: A gasoline tax

Suppose that in the state of Virginia, there is initially no gasoline tax

The gasoline market is in equilibrium at point E1, where the price is $2 per gallon and the quantity sold is 10 million gallons per day

June 21, 2014 Ed Dolan’s Econ Blog

Page 4: Who Really Pays Taxes? The Question of Tax Incidence

Elasticity of Supply and Demand

The elasticity of supply and demand will play an important part in our story

Elasticity means the percentage change in quantity associated with a 1 percent change in price

Notice that in the neighborhood of the equilibrium point, supply is more elastic than demand, that is, a 1 percent change in price would cause a larger percentage change in the quantity supplied than in the quantity demanded

June 21, 2014 Ed Dolan’s Econ Blog

Page 5: Who Really Pays Taxes? The Question of Tax Incidence

Effect of a $1 per Gallon Tax on the Supply Curve

Now suppose the state imposes a $1 per gallon tax

Sellers will be willing to supply the same quantity as before only if they can raise the price including tax by $1

That means the tax-inclusive supply curve shifts upward by $1, from S1 to S2

The old supply curve S1 shows what is left for sellers after the tax is paid

June 21, 2014 Ed Dolan’s Econ Blog

Page 6: Who Really Pays Taxes? The Question of Tax Incidence

Effects of a $1 per Gallon Tax on Quantity Supplied and Demanded

The tax will affect the choices made by buyers as well as sellers

As sellers attempt to pass the tax along, consumers will move up and to the left along the demand curve, reducing the quantity demanded

As buyers purchase less gasoline, sellers will move down and to the left along S1

June 21, 2014 Ed Dolan’s Econ Blog

Page 7: Who Really Pays Taxes? The Question of Tax Incidence

New Equilibrium After the Tax

Consumers will continue to move along their demand curve until they reach point E2, where the quantity demanded at the price including tax equals the quantity supplied

In the new equilibrium, the price, including tax, will be $2.80 and the quantity will fall to 8 million gallons per day

The price received by sellers, after the tax is paid, will fall to $1.80

June 21, 2014 Ed Dolan’s Econ Blog

Page 8: Who Really Pays Taxes? The Question of Tax Incidence

Incidence of the Gasoline Tax

In the new equilibrium, total tax revenue will be $8 million per day, equal to the area of the entire shaded rectangle ABFE

Consumers will bear 80% of the burden ($6.4 million), equal to the blue shaded area ABDC, because the price they pay including tax has gone up by 80 cents

Sellers will bear 20% of the burden ($1.6 million), equal to the tan area CDFE, because the price they receive after the tax is paid goes down by 20 cents

June 21, 2014 Ed Dolan’s Econ Blog

Page 9: Who Really Pays Taxes? The Question of Tax Incidence

Example 2: A tax on apartment rents

For our second example, consider the market for rental apartments in a small city

In equilibrium 2,000 apartment units are rented at a rental price of $500 per month

June 21, 2014 Ed Dolan’s Econ Blog

Page 10: Who Really Pays Taxes? The Question of Tax Incidence

Elasticity of Supply and Demand

Compared with the market for gasoline, demand is more elastic, because owning a house or condominium is a good substitute for renting an apartment

The supply is less elastic. An increase in rents will make a few more apartments available, but not very many, at least in the short run

June 21, 2014 Ed Dolan’s Econ Blog

Page 11: Who Really Pays Taxes? The Question of Tax Incidence

Effect of a $250 tax on the Supply Curve

Now suppose the city imposes a $250 per month on apartment rentals

Owners will be willing to supply the same quantity as before only if they can raise the rent including tax by $250

That means the tax-inclusive supply curve shifts upward by $250, from S1 to S2

The old supply curve S1 shows what is left for owners after the tax is paid

June 21, 2014 Ed Dolan’s Econ Blog

Page 12: Who Really Pays Taxes? The Question of Tax Incidence

Effects on owners and renters

The tax will affect the choices made by renters as well as owners

As owners attempt to pass the tax along, renters will move up and to the left along the demand curve, reducing the quantity demanded

As occupancy of rental apartments decreases, owners will move down and to the left along S1

June 21, 2014 Ed Dolan’s Econ Blog

Page 13: Who Really Pays Taxes? The Question of Tax Incidence

Equilibrium after tax

Renters will continue to move along their demand curve until they reach point E2, where the quantity demanded at the price including tax equals the quantity supplied

In the new equilibrium, the rent, including tax, will be $550 and the number of apartments occupied will decrease to 1,600 units

The rental price per month received by owners, after the tax is paid, will fall to $300

June 21, 2014 Ed Dolan’s Econ Blog

Page 14: Who Really Pays Taxes? The Question of Tax Incidence

Incidence of the Rental Tax

In the new equilibrium, total tax collected by the government will be $400,000 per month, equal to the area ABFE

Renters will bear 20% of the burden, or $80,000 per month, equal to the area ABDC, because the price they pay including tax has gone up by $50

Owners will bear 80% of the burden, or $320,000 per month, equal to the area CDFE, because the price they receive after the tax is paid goes down by $200

June 21, 2014 Ed Dolan’s Econ Blog

Page 15: Who Really Pays Taxes? The Question of Tax Incidence

Conclusions

The incidence of a tax depends on the relative elasticity of supply and demand

If supply is more elastic than demand, more of the economic burden of the tax will be born by customers than by suppliers

If demand is more elastic than supply, more of the burden will be born by suppliers than by customers

If demand and supply are equally elastic, the economic burden of the tax will be divided equally

June 21, 2014 Ed Dolan’s Econ Blog


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