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NPTEL-Economics-Public Economics
Module 8
Lecture 32
Topics
8.4 Extensions of Basic Partial Equilibrium Analysis
8.5 Tax Incidence in Factor Markets
8.6 Tax Incidence Extensions
Tax Incidence in Factor Markets
8.7 Tax Incidence in Imperfectly Competitive Markets
8.8 Formula for Tax Incidence
8.4 EXTENSIONS OF BASIC PARTIAL EQUILIBRIUM
ANALYSIS
Market rigidities: When there are barriers to reaching the competitive market
equilibrium, the side of the market on which the tax is levied can matter.
– Minimum wages
– Workplace norms
– Union rules
Imperfect competition: Monopoly or Oligopoly
Effects on other markets: General Equilibrium
8.5 TAX INCIDENCE IN FACTOR MARKETS
TAX ON WORKERS:
Various taxes are levied on the factors of production, such as labor.
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NPTEL-Economics-Public Economics
The workers now get a wage of 5.65
which is more than the previous
wage of 5.15. However they must
pay a tax of 1 unit/hr.
Their net wage is 4.65, lower
than 5.15 by 0.5 units/hr.
The firms were earlier paying a
wage of 5.15 but now have to pay
5.65.
So the burden on the firms is 0.5
units/hr.
Figure 32.1
FB
firm burden, WB
worker burden.
A 1 unit/hr tax lowers the return to work at every unit of labor.
Thus individuals require a 1 unit increase in their wages to supply any amount
of labor and the supply curve shifts up.
With labor demand unchanged, new equilibrium wage to 5.65. Tax in borne
partly by the workers, partly by the firms.
TAX ON FIRMS:
Figure 32.2
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NPTEL-Economics-Public Economics
With tax on firms, the demand curve shifts down to
Wage to 4.65 at the new equilibrium point c.
Firms pay workers 0.5 less than original 5. 15 but also pays 1 unit of tax to the
government in effect paying 5 .65.
It makes no difference to Tax incidence, which side of the market the tax is
levied on & economic burden varies from statutory burden
As in output markets, the tax incidence of an income tax shows that it makes
no difference on which side of the market the tax is levied on, and the
economic burden varies from statutory burden.
8.6 TAX INCIDENCE IN THE PRESENCE OF MARKET
IMPERFECTIONS
The above analysis will not be correct if there are impediments to wage
adjustments.
The minimum wage is a legally mandated minimum amount that workers must be
paid for each hour of work.
What happens to tax incidence in the presence of a minimum wage?
– With a minimum wage, wages cannot fully adjust, so the incidence will be
different.
THE CASE OF MINIMUM WAGES - TAX ON WORKERS:
Figure 32.3
With tax on workers, the labor supply curve shift up as before
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Indian Institute Of Technology, Kanpur
NPTEL-Economics-Public Economics
Workers are paid 5.65/hr, but are forced to pay 1 unit of that to the government as
taxes.
The incidence is borne in the same manner as when there was no min wage.
THE CASE OF MINIMUM WAGE-TAX ON FIRMS:
Figure 32.4
With a tax on firms, the labor demand curve shifts down. Without wage
impediments, the market wage would from 5. 15 to 4.65 & the firm would pay 1
unit in taxes, hrs of work would be .
With min wage at
, wage cannot downward so the firm will reduce quantity
demanded to
, hours of labor. Pay 5. 15 per hr to labor & also a tax of
1unit to government.
The economics burden is entirely on firms in this case.
8.7 TAX INCIDENCE IN IMPERFECTLY COMPETITIVE
MARKETS
Monopoly: Rules of tax incidence under competition continue to apply.
Oligopoly:
– There is less consensus on how to model these markets.
– Economists tend to assume the tax incidence results apply in these markets
as well.
However, Over shifting might happen: possible to get an increase in after-tax
price greater than the level of the tax.
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NPTEL-Economics-Public Economics
Figure 32.5
The analysis has so far focused on competitive markets.
Consider a monopoly market structure where tax is levied on consumers.
Monopolists are price makers, not price takers. Unlike a perfect competitor, the
monopolist faces a downward sloping marginal revenue curve, because it must
lower its price on all units to sell another unit.
The marginal revenue curve, MR1, is therefore everywhere below the demand
curve. Setting MR1=MC, the quantity Q1 initially maximizes profits.
With a tax on consumers, both demand-curve and marginal revenue curve would
change.
The tax on consumers shifts the demand curve downward to D2, and the
associated marginal revenue curve to MR2.
Setting MR2=MC, the quantity Q2 now maximizes profits.
The monopolist’s price falls from P1 to P2, so it bears some of the tax, just as a
competitive firm does. The rest of the burden is borne by the consumers.
The three rules of tax incidence continue to apply for a monopolist.
8.8 TAX INCIDENCE CALCULATION: TAX ON
CONSUMERS
Taking full derivative we get:
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NPTEL-Economics-Public Economics
Evaluated at equilibrium price and quantity with no tax this becomes
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Indian Institute Of Technology, Kanpur