7.2 Tax Incidence and Elasticity

Overview

This lecture explains how the burden of a tax is shared between buyers and sellers depending on the relative elasticity of demand and supply.

Tax incidence describes who ultimately bears the cost of a tax—buyers or sellers.
The burden of a tax depends on the relative elasticity (responsiveness to price changes) of demand and supply, not on who the tax is levied on.
If demand is less elastic (steeper) than supply, buyers bear more of the tax burden.
If supply is less elastic (steeper) than demand, sellers bear more of the tax burden.
The less elastic side of the market cannot easily adjust their behavior and thus pays more of the tax.

With perfectly inelastic demand (vertical line), buyers bear the full tax burden (e.g., insulin).
With elastic demand (many substitutes), sellers bear more of the tax burden (e.g., luxury goods like yachts).
The 1990 luxury tax intended to tax wealthy buyers ended up hurting sellers and industry workers due to elastic demand.
A study found the yacht tax led to significant job losses, showing how sellers can be disproportionately affected.

The payroll (FICA) tax is split on paper between employer and employee.
In reality, labor supply is relatively inelastic, so workers bear most of the payroll tax burden, not employers.

Elasticity — The responsiveness of buyers or sellers to price changes.
Tax Incidence — The division of tax burden between buyers and sellers.
Inelastic Demand/Supply — Little response to price changes; shown by a steeper curve.
Elastic Demand/Supply — Strong response to price changes; shown by a flatter curve.
Perfectly Inelastic Demand — Demand does not change at all with price; vertical demand curve.

Practice identifying tax incidence using elasticity in sample problems.
Review demand and supply curves and understand their elasticities.
Complete any assigned reading on tax policy and market elasticity before next class.