Tax Incidence And Efficiency Costs Flashcards
Tax incidence
Assessing which party (consumer or producers) bears the true burden of the tax
Effect of tax on producers vs tax on consumers pg 7
Tax burden is is identical, regardless of the statutory burden (who actually gets taxed)
Both have the same producer and consumer burdens
Pg 7 shows diagram example of tax on producers vs a tax on consumers, creating the same burden effects
A $0.50 tax
For tax on producers: shift left in supply
Consumer burden is A to D: $0.30 as price they pay as a result of the tax increases from $1.50 to $1.80
So the rest of the $0.50 is $0.20 which the producers hold the burden to A to E.
For tax on consumers: shift left in demand
Same thing.
So we have q=p+t
Demand for good X is D(q)
(Demand is a function of price q)
Supply for good X is S(p),
(Supply a function of pre-tax price, increases with p)
What is the equilibrium condition
Q = S(p) = D(p+t)
(Subbed in our value of q into demand function)
dp/dt expression
B) what does it represent
dp/dt = Ed / Es - Ed
Where Ed (PED) is negative, and Es is positive
B) dp/dt shows effect of small tax increase on price (if large, consumers bear burden, if small producers bear burden)
When do consumers bear the entire burden of the tax (2)
If inelastic demand i.e εD = 0, since they’ll pay regardless of the price change (e.g if a necessity)
If perfectly elastic supply i.e εS = ∞ e.g a perfectively competitive market, will not supply if price falls, thus burden of tax falls on consumers.
When do producers bear the entire burden of the tax
If inelastic supply i.e εS = 0 (they can’t adjust/reduce quantity to avoid tax, so tax taken from producers)
If perfectly elastic demand, as demand will completely drop if price changes, thus producers must suffer all the burden
Diagram of perfectly inelastic demand, show who incurs the burden
Vertical demand line to show elasticity :
Consumers fully incur the burden due to their inelastic demand
Diagram of perfectly elastic demand, show who incurs the burden
Horizontal demand curve, show a shift left in supply to show how all the burden will be on the producer
E.g since all demand will be lost if they increase price, so thus incur all the burden
Diagram of inelastic supply, show who incurs the burden (not perfectly inelastic, just inelastic!)
Producers bear burden
Diagram of elastic supply, show who incurs the burden
Consumers bear burden
So which factor tends to bear the tax
More inelastic factors bear more of the tax (inelastic demand = consumers bear the burden, inelastic supply = producers bear the burden)
Deadweight/excess burden
The welfare loss created from a tax over and above the tax revenue generated
Welfare loss of tax formula (DWL)
Change in CS + change in PS - tax collected
I.e the triangle leftover
How is inefficiency of tax created
If consumers and producers change their behaviour, making inefficient consumption and production choice to avoid tax
I.e if no change in quantities consumed, there are no efficiency costs (no DWL)
DWB formula
1/2 x [εSεD / εS - εD] x Q/P (dt)²
DWB increases with: (3)
Elasticities - as they become more elastic. (So taxing inelastic goods is more efficient since smaller DWL)
Square of tax rate t: small tax have small efficiency costs, large taxes have large efficiency costs, higher DWL
Pre-existing distortions e.g existing tax increases marginal DWL, triangle to trapezoid!
So which goods is it more efficient to tax? Elastic or inelastic
Inelastic, since less DWL
So DWB also increases with squares of tax rate t:
How should policymakers tax then
More efficient to spread taxes across all goods to keep each tax rate low (small taxes have small efficiency loses), rather than just one large tax to earn tax revenue
Pg 19: draw inelastic demand and elastic demand to show which one has more DWL
We said (marginal) DWL increases with pre-existing distortions e.g a pre-existing tax.
How can we show marginal DWL increases? pg 20
If we are increasing tax further, the extra (marginal) DWL is a trapezoid (shown by BCDE), meaning total DWL with the further tax is ADE
So just basically draw one tax, and then a further shift left S3, so the additional (MARGINAL) DWL is a trapezoid
DWL increases with square of t.
So we should spread taxes across goods, small taxes opposed to one single large tax. But we can’t have uniform tax rates (t1=t2=…=tk) if the consumer’s elasticity of demand varies per good
How do we find the tax rates for each good while minimising welfare loss to individual
Ramsey tax rule: optimal tax rate is where marginal DWB from last dollar of tax is equal across goods
I.e tax more inelastic demand goods, and less for elastic demands, to make marginal DWB equal
Findings of 10 cent increase in gas tax
7% increase in price paid for consumers
I.e consumer bear 70% of incidence/burden!
Which good consumers bear full burden
Cigarettes
