Tax Incidence and Economic Implications

Key Concepts

• Tax Incidence

  • Refers to how the burden of a tax is divided between consumers and producers.
  • Economic incidence is independent of the legal incidence (who the law states must pay).

• Economic vs. Legal Incidence

  • Economic incidence: Who actually ends up paying the tax.
  • Legal incidence: Who is legally obliged to pay the tax.

Effects of Taxation

• When a tax is imposed:

  • Consumers may pay more for products.
  • Producers may receive less for their products.
  • Overall, the market adjusts to distribute the tax burden.

• Example:

  • If consumers paid $20 pre-tax and $25 post-tax, they bear $5 of the tax.
  • If the tax was $10, the burden is split equally between consumers and producers.

Deadweight Loss

• Excess Burden of Taxation
  • Deadweight loss arises from taxes because they prevent mutually beneficial trades.
  • Tax revenue = Tax Rate × Quantity with tax.
  • Deadweight loss = Consumer and producer surplus lost.

Elasticity and Tax Burden

• Elasticity Impact

  • Elasticity affects how tax burdens are split between consumers and producers.
  • "Elasticity equals escape": More elastic = less tax burden.

• Demand and Supply Elasticity

  • If demand is less elastic than supply, consumers bear more of the tax.
  • If supply is less elastic than demand, producers bear more of the tax.

Calculating Tax Shares

• Formulas
  • Consumer share = Elasticity of Supply / (Elasticity of Supply - Elasticity of Demand)
  • Producer share = - Elasticity of Demand / (Elasticity of Supply - Elasticity of Demand)

Example Calculation

• Given Values

  • Elasticity of Supply: 0.8 (inelastic)
  • Elasticity of Demand: -1.2 (elastic)
  • Tax: $10

• Tax Share Results

  • Consumers pay 40% of the tax: $4 increase in price for consumers.
  • Producers pay 60% of the tax: $6 decrease in earnings for producers.

• Calculation Steps

  • Consumer Share: 0.8 / (0.8 - (-1.2)) = 40%
  • Producer Share: (-(-1.2)) / (0.8 - (-1.2)) = 60%

These calculations demonstrate how different elasticities influence the distribution of tax burdens between consumers and producers.