1,Chapter 12 Taxation and Income Distribution,2,Introduction,Many policies center around whether the tax burden is distributed fairly. Not as simple as analyzing how much in taxes each person actually paid, because of tax-induced changes to price.,3,Introduction,Two main concepts of how a tax is distributed: Statutory incidence who is legally responsible for tax Economic incidence the true change in the distribution of income induced by tax. These two concepts differ because of tax shifting.,4,Tax Incidence: General Remarks,Only people can bear taxes Business paying their fair share simply shifts the tax burden to different people Can study people whose total income consists of different proportions of labor earnings, capital income, and so on. Sometimes appropriate to study incidence of a tax across regions.,5,Tax Incidence: General Remarks,Both Sources and Uses of Income should be considered Tax affects consumers, workers in industry, and owners Economists often ignore the sources side,6,Tax Incidence: General Remarks,Incidence depends on how prices are determined Industry structure matters Short- versus long-run responses,7,Tax Incidence: General Remarks,Incidence depends on disposition of tax revenue Balanced budget incidence computes the combined effects of levying taxes and government spending financed by those taxes. Differential tax incidence compares the incidence of one tax to another, ignoring how the money is spent. Often the comparison tax is a lump sum tax a tax that does not depend on a persons behavior.,8,Tax Incidence: General Remarks,Tax progressiveness can be measured in a number of ways A tax is often classified as: Progressive Regressive Proportional Proportional taxes are straightforward: ratio of taxes to income is constant regardless of income level.,9,Tax Incidence: General Remarks,Can define progressive (and regressive) taxes in a number of ways. Can compute in terms of Average tax rate (ratio of total taxes total income) or Marginal tax rate (tax rate on last dollar of income),10,Tax Incidence: General Remarks,Measuring how progressive a tax system is present additional difficulties. Consider two simple definitions. The first one says that the greater the increase in average tax rates as income rises, the more progressive is the system.,11,Tax Incidence: General Remarks,The second one says a tax system is more progressive if its elasticity of tax revenues with respect to income is higher. Recall that an elasticity is defined in terms of percent change in one variable with respect to percent change in another one:,12,Tax Incidence: General Remarks,These two measures, both of which make intuitive sense, may lead to different answers. Example: increasing all taxpayers liability by 20%,13,Partial Equilibrium Models,Partial equilibrium models only examine the market in which the tax is imposed, and ignores other markets. Most appropriate when the taxed commodity is small relative to the economy as a whole.,14,Partial Equilibrium Models: Per-unit taxes,Unit taxes are levied as a fixed amount per unit of commodity sold Federal tax on cigarettes, for example, is 39 cents per pack. Assume perfect competition. Then the initial equilibrium is determined as (Q0, P0) in Figure 12.1.,Figure 12.1,16,Partial Equilibrium Models: Per-unit taxes,Next, impose a per-unit tax of $u in this market. Key insight: In the presence of a tax, the price paid by consumers and price received by producers differ. Before, the supply-and-demand system was used to determine a single price; now there is a separate price for each.,17,Partial Equilibrium Models: Per-unit taxes,How does the tax affect the demand schedule? Consider point a in Figure 12.1. Pa is the maximum price consumers would pay for Qa. The willingness-to-pay by demanders does NOT change when a tax is imposed on them. Instead, the demand curve as perceived by producers changes. Producers perceive they could receive only (Pau) if they supplied Qa. That is, suppliers perceive that the demand curve shifts down to point b in Figure 12.1.,18,Partial Equilibrium Models: Per-unit taxes,Performing this thought experiment for all quantities leads to a new, perceived demand curve shown in Figure 12.2. This new demand curve, Dc, is relevant for suppliers because it shows how much they receive for each unit sold.,Figure 12.2,20,Partial Equilibrium Models: Per-unit taxes,Equilibrium now consists of a new quantity and two prices (one paid by demanders, and the other received by suppliers). The suppliers price (Pn) is determined by the new demand curve and the old supply curve. The demanders price Pg=Pn+u. Quantity Q1 is obtained by either D(Pg) or S(Pn).,21,Partial Equilibrium Models: Per-unit taxes,Tax revenue is equal to uQ1, or area kfhn in Figure 12.2. The economic incidence of the tax is split between the demanders and suppliers Price demanders face goes up from P0 to Pg, which (in this case) is less than the statutory tax, u.,22,Numerical Exam