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Tax Incidence
An Application of Supply and Demand
 A sales tax is a tax on a wide variety of goods.
 An excise tax is a tax on a specific good.
 An ad valorem tax is expressed as a percentage of a
good’s price or value.
 A unit tax is a fixed amount per unit of a good.
 Statutory tax incidence is concerned with who is
legally required to pay a tax.
 Economic tax incidence is concerned with who
ultimately bears the burden of a tax.
The introduction of a tax often results in changes in market
prices, which in turn results in the economic incidence of the
tax differing from the statutory incidence.
Consider a $0.60 per gallon tax on the sellers of gasoline.
Unit Tax (statutorily) Imposed on Sellers
P
$ per
gallon
1.80
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
S’
S
A tax on sellers of
$0.60 per gallon
will shift the supply
curve upward by
$0.60.
10 20 30 40 50 60 70 80 90 Q
(millions of gallons)
P
$ per
gallon
1.80
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
S’
$0.60
S
D
10 20 30 40 50 60 70 80 90 Q
(millions of gallons)
Here a $0.60 tax per unit causes the (gross) price of gas paid by buyers to
increase by $0.40 and the (net) price received by sellers to fall by $0.20.
Changes in market prices typically result in the ultimate burden of a tax (i.e.,
the economic incidence) being at least partially shifted away from those
statutorily required to pay the tax.
Unit Tax (statutorily) Imposed on Buyers
P
$ per
gallon
1.80
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
A tax on buyers of $0.60 per gallon will
cause the demand curve to shift down by
$0.60.
D
D’
10 20 30 40 50 60 70 80 90 Q
(millions of gallons)
P
$ per
gallon
1.80
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
$0.60
S
D
D’
10 20 30 40 50 60 70 80 90 Q
(millions of gallons)
Here a $0.60 tax per gallon of gas causes the (gross) price of gas paid by buyers
to increase by $0.40 and the (net) price received by sellers to fall by $0.20.
P
$ per
gallon
1.80
1.60
$0.60
1.80
1.60
S
1.40
1.20
1.00
0.80
0.60
0.40
0.20
S’
P
$ per
gallon
D
$0.60
S
1.40
1.20
1.00
0.80
0.60
0.40
0.20
10 20 30 40 50 60 70 80 90 Q
(millions of gallons)
D
D’
10 20 30 40 50 60 70 80 90 Q
(millions of gallons)
The economic incidence is the same whether buyers or sellers
are statutorily liable for the tax.
S’
P
u
S
Pg1
P0
Pn 1
D
Q1
Q0
Q
(Pg1 - P0) + (P0 - Pn1) = Pg1 - Pn1 = u
The increase in the gross price paid by buyers plus the decrease in the
net price received by sellers equals the tax per unit of the good.
S’
P
u
S
tax revenue:
R = u • Q1
Pg1
P0
Pn 1
D
Q1
Q0
Q
P
S’
(Pg1 - P0) • Q1
u
S
tax revenue:
R = u • Q1
Pg1
P0
(P0 - Pn1) • Q1
Pn 1
D
Q1
Q0
Q
( P1g  P0 )  Q1 ( P1g  P0 )

Buyers’ share of the tax burden: K B 
u  Q1
u
Sellers’ share of the tax burden:
( P0  P1n )  Q1 ( P0  P1n )
KS 

u  Q1
u
Who bears the burden of a tax crucially
depends upon the price elasticities of demand
and supply.
S’
S’
P
P
Pg2
S
Pg1
P0
S
P0
Pn 2
Pn 1
D2
D1
Q1
Q0
Q
Q2 Q0
S’
P
Pg2
Pg1
S
P0
Pn 2
Pn 1
D2
Q1
Q2 Q0
D1
Q
Q
S’
P
Pg2
Pg1
S
P0
Pn 2
Pn 1
D2
Q1
Q2 Q0
D1
Q
With the less elastic demand (D2), the gross price paid by buyers is higher.
With the less elastic demand (D2), the net price received by sellers is higher.
The share of the tax burden borne by buyers will be larger (and
the share borne by sellers will be smaller) as demand is less elastic
with respect to price.
P
P
S2
S1
Pg1
Pg2
P0
P0
Pn 1
D’
Q1
Q0
Pn 2
D
D’
Q
P
Q2 Q0
S2
S1
Pg1
Pg2
P0
Pn 1
Pn 2
D’
Q1 Q2 Q0
D
Q
D
Q
P
S2
S1
Pg1
Pg2
P0
Pn 1
Pn 2
D’
Q1 Q2 Q0
D
Q
With the more elastic supply (S1), the gross price paid by buyers is higher.
With the more elastic supply (S1), the net price received by sellers is higher.
The share of the tax burden borne by buyers will be larger (and
the share borne by sellers will be smaller) as supply is more
elastic with respect to price.
The portion of a unit tax borne by buyers, KB, can be shown
to equal K B 
Es
1

Ed
Ed  E s
1
.
Es
The portion of a unit tax borne by sellers, KS, can be shown
to equal
KS 
Ed
1

Ed  E s 1  E s
.
Ed
Thus, the economic incidence of a tax depends upon the
magnitude of Ed relative to the magnitude of Es, as the ratio
Ed / Es determines the shares of the tax burden borne by buyers
and sellers.
KB 
Es
1

Ed
Ed  E s
1
Es
KS 
Ed
1

Ed  E s 1  E s
Ed
As Ed / Es is smaller, ...
the portion of a tax borne by buyers will be larger and
the portion of a tax borne by sellers will be smaller.
As Ed / Es is larger, ...
the portion of a tax borne by buyers will be smaller and
the portion of a tax borne by sellers will be larger.
Price Ceilings & Price Floors
Price Ceiling
A legally established maximum price at which a
good can be sold.
Price Floor
A legally established minimum price at which a
good can be sold.
Price Ceilings
Two outcomes are possible when the
government imposes a price ceiling:

The price ceiling is not binding if set above
the equilibrium price.
 The price ceiling is binding if set below the
equilibrium price, leading to a shortage.
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Price Ceiling That Is Not Binding...
Price of
Ice-Cream
Cone
Supply
Price
ceiling
$4
3
Equilibrium
price
Demand
0
100
Equilibrium
quantity
Quantity of
Ice-Cream
Cones
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Price Ceiling That Is Binding...
Price of
Ice-Cream
Cone
Supply
Equilibrium
price
$3
Price
ceiling
2
Shortage
Demand
0
75
Quantity
supplied
125
Quantity
demanded
Quantity of
Ice-Cream
Cones
Rent Control
Rent controls are ceilings placed on
the rents that landlords may charge
their tenants.
The goal of rent control policy is to
help the poor by making housing more
affordable.
One economist called rent control “the
best way to destroy a city, other than
bombing.”
Rent Control in the Short Run...
Rental
Price of
Apartment
Supply
Supply and
demand for
apartments
are relatively
inelastic
Controlled rent
Shortage
Demand
0
Quantity of
Apartments
Rent Control in the Long Run...
Rental
Price of
Apartment
Because the
supply and
demand for
apartments are
more elastic...
Supply
…rent control
causes a large
shortage
Controlled rent
Shortage
Demand
0
Quantity of
Apartments