Tax Incidence and DWL Flashcards
What is tax incidence
the study of the effects of tax policies on prices and the economic welfare of individuals
Principles of Tax Incidence
1) The statutory burden of the tax does not describe who really bears the tax
2) Who remits the tax is irrelevant to the distribution of the tax burden
3) Parties with inelastic supply or demand bear taxes; parties with elastic demand or supply avoid the burden
4) People pay taxes
Ad-Valorem Tax
a tax that is a fraction of prices (e.g. 5% sales tax)
Excise Tax
Tax is levied on a quantity and typically fixed in nominal terms
Tax inclusive price of a good with tax applied
p^c = p+dt
where:
p denotes pretax price of x
dt is tax per unit
formula for dp/dt
dp/dt = ED/(ES - ED)
When do consumers bear the entire burden of the tax?
Ed=0 (inelastic demand) OR Es = infinity (perfectly elastic supply)
When do producers bear the entire burden of the tax?
Es = 0 (inelastic supply) OR Ed = -infinity (perfectly elastic demand)
Tax incidence in the short run vs long run
Not necessarily the same, depends on factors
Capitalisation
The process by which a stream of taxes becomes incorporated into the price of an asset
Key results of tax incidence
1) equilibrium is independent of who statutorily pays the tax (whether tax is charged on producer or consumer)
2) more inelastic factor bears more of the tax
Deadweight burden/excess burden of taxation
the welfare loss created by tax over and above the tax revenue generated by the tax
How inefficiency of any tax is determined
The extent to which consumers and producers change their behaviour to avoid the tax
Things to remember about DWB
1) DWB increases with the absolute sizes of elasticities Es>0 and -Ed>0
2) DWB increases with the square of the tax rate t: small taxes have relatively small efficiency costs, large taxes have relatively large efficiency costs
3) pre-existing distortions makes the cost of taxation higher
Formula for DWB
DWB = 1/2(1/(1/-Ed+1/Es)) (Q/P)(dt)^2
