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CHAPTER 3
TAXATION AND INCOME DISTRIBUTION
3.1 Introduction
In Chapter 2 we discussed the theory of government expenditure in term of the provision of public
goods. This chapter focuses on how to finance the provision of public goods as a component of
government expenditure.
Taxes are the main source of government revenue for financing government expenditure. The greater
the government expenditure in the economy, the higher the demands on the government raising tax
revenue. The implication is that many countries have implemented tax reform to increase tax
revenues. Examples include the case of China (Bahl, 1999a), the case of Australia (Jonson, 2006), the
case of Japan (Horioka and Sekita, 2007), the case of Russia (Martinez, Rider and Wallace, 2008),
(Bawazier and Kadir, Nasution in Abimayu, 2009) in Indonesia and (World Bank Report and Georgia
State University, 2009) in Pakistan. Performance of the tax system in Russia after the tax reform
changed significant. For example, the share of tax revenue to GDP in the 1990s decreased from 26.4
percent of GDP in 1992 to 19.85 percent of GDP in 1998. After the tax reform, tax revenue’s share of
GDP increased to reach 32.68% in 2005. However, it should be noted that not all countries that have
conducted tax reform experience an increase revenues. Tax reform efforts are not something easily
done by many countries. Countries face various obstacles and challenges when trying to implement tax
reform. It should also be noted that tax reform is not done just once but often several times in a
country.
In regards to Indonesia, the tax system has been undertaken several times. During the period 19942008, tax reform continues in effect to increase self-reliance in development funding. Ten years after
the first tax reform, or rather in 1994, the government has sought to improve tax provisions in order to
reflect justice, legal certainty (for taxpayers and tax officials), and efficiency. During this period, much
of country’s the tax law was established including the Law of Income Tax, the Value Added Tax, and
the property tax. In 2003 tax reform was sought back especially in regards to tax administration in the
medium and long term. In 2007 and 2008 the Directorate General of Taxes established the provisions
of the General Tax Procedures and Income Tax laws as a refinement of the previous regulation. These
tax reforms were aimed at reducing inefficiency and increasing state revenues.
Changes in tax rates are one form of tax reform that will have a large impact on the economy. Taxes
may or may not improve distribution of income. Similarly, taxes may make the economy better or
worse off depending on the economic efficiency or inefficiency that they create. That is why, when the
government tries to make changes to the tax system, such as the level of tax rates, it is not surprising
that debates were had over who bears the burden of taxes and who these taxes should be imposed
on? Are taxes imposed on consumers and producers fairly distributed? This question invites us to
discuss the question of how taxes affect real income distribution. This chapter describes the theory of
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taxation and income distribution. Discussion topics include tax incidence and the tax incidence through
partial equilibrium and general equilibrium models.
3.2. Defining tax incidence
Basically, an analysis of the theory of taxation consists of two parts; tax incidence and excess burden.
Tax incidence analyzes which individuals bear the ultimate burden of taxes, that is, who bears the
burden after the economy has adjusted to any changes caused by the taxes? Incidence is usually
defined as the change in real private incomes and wealth as the result of the adoption or change of a
tax. When government imposes taxes on certain commodities, which should bear the tax burden,
consumers or producers? A consumer may bear the tax if they buy the commodity and will not bear
the tax burden if they do not consume the commodity. The broader definition proposed by Sennoga,
Sjoquist and Wallace (2008) that tax incidence is how the prices of factors of production and final
goods and services change as a result of a tax. This means that tax affects on real incomes and wealth
for both producer and consumers through the changes of the prices of factors production and final
goods and services.
When the firm charges the higher price level to consumers, consumers are only able to buy
commodities in a number of smaller. This means that consumers bear some of the tax burden. At the
same time, producers also bear some of the tax burden by accepting a lower price. Thus, if consumers
want to avoid the tax burden, they simply reduce the amount of the product they consume or they can
stop consuming the product. In a similar manner, firms may respond to higher taxes by selling in
smaller quantities.
There are two important terms that must be understood in relation to tax incidence analysis: the
statutory incidence and economic incidence. Statutory incidence of a tax burden created by an
individual or firm who sent a check to the government. Or statutory tax incidence is determined by
who pays taxes to the government (Gruber, 2005). For example gasoline producers pay taxes to the
government because that's the producer is imposed by tax (according to statutory incidence). In fact,
the rules were not always to be valid because market can react to respond the tax. This reaction is
called the economic incidence. Incidence tax is the tax burden measured through changes in the
resources available to any economic agent as a result of taxation. For example, when a tax is imposed
on gasoline producers in a perfectly competition market, producers raise prices to offset the tax
burden and income producers will not fall by the amount of tax. The same thing for the consumer,
when a tax is imposed on consumers in a perfectly competitive market, consumers will not want to pay
taxes as much as commodity taxes.
There are three rules regarding tax incidence as described by Gruber (2005);
(i) The Statutory burden of a tax does not describe who really bears the tax. This ambiguity creates a
market reaction. The reaction changes the resources available and then changes the behavior of
economic agents. If the tax is borne by producers (statutory incidence), in fact it is partly borne by
the consumers as well because producers can increase the prices to offset commodity taxes.
Consumers can reduce the number of items purchased to offset price increases due to taxes.
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(ii) The size of the market on which the tax is imposed is irrelevant to the distribution of the tax
burdens. Tax incidence is identical whether the taxes are levied on producers or consumers. With
certain tax rates charged to producers and consumers, consumers will always bear a greater tax
and producers bear a number of smaller taxes. This means that the imposition of taxes in perfectly
competitive markets is not relevant to the distribution of tax burdens. This occurs because of the
market mechanism.
(iii) Parties with inelastic supply and demand bear taxes; parties with elastic supply and demand avoid
taxes. When a tax is levied on producers and consumers' demand curve is perfectly inelastic, it
means that the tax increase is entirely borne by consumers. If the demand curve is perfectly
elastic, producers bear the entire burden of taxation. To analyze in more detail the influence of tax
incidence on income distribution, the following describes two models related to the incidence of
tax: partial equilibrium model and general equilibrium models.
3.3. Partial Equilibrium Model of Tax Incidence
In this section, we describe the effects of a commodity tax (unit tax on the commodity) by using a
partial equilibrium model. How can producers and consumers respond to the tax? How does the tax
affect price and quantity?
 Unit taxes on commodity imposed by producers
A unit tax is a tax levied on commodities with a certain value. For example the government imposes
a tax on gasoline that must be paid by the firm. Figure 3.1 shows the equilibrium price and quantity
before tax. The vertical axis shows the price of gasoline per liter and the horizontal axis shows the
quantity demanded. Dg shows the market demand curve for gasoline, Sg shows the supply curves
for gasoline. In a perfectly competitive market, the amount of gasoline bought by consumers and
produced by the suppliers is represented by Q *= 10 at equilibrium price level P *= 5 (thousand
rupiahs). At this point the producers are willing to produce at 10 because of the firm's marginal
cost of producing gasoline.
Now, suppose that the government imposes a tax on gasoline of 1500 rupiah per liter. Do
producers receive less than 1500 per liters of their production due to taxes? When a tax of 1500 is
levied on producers, this is equivalent to an increase in the marginal cost of producing gasoline.
Because the firms must pay the original cost and the marginal tax rate of 1500, the firm will
increase the price of gasoline. In order to produce the same quantity of gas as before, firms must
raise prices by 6500 rupiah.
At the equilibrium conditions, where P *= 5000, there is excess demand. The amount requested by
the consumer is 10, while the amount of gasoline to be sold by the firms is 8, at point C. At the
price of 5000, there is shortage of gas production as much as 2 that is (10 – 8). Following a perfectly
competitive market system, consumers compete for the available quantity for the firm. As a result,
the consumer price is continuously increasing to arrive at the new equilibrium at the point of A.
Now, the price at P3= 6000 is higher than before tax, and the quantity is 9.
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Figure 3.1 Incidence of Tax Unit Imposed to Producers
Pg
Per liter (Rp)
S’g
Consumers
Burden =1000
D
P2=6500
Sg
A
P3=6000
E
P*=5000
P1=4500
C
B
Producer
burden= 500
Dg
8
9
Q*=10
Qg
Figure 3.1 Incidence tax unit imposed to producer
The question is how the tax will affect consumers and producers? In the new equilibrium, there
are two prices; the price paid by consumers and the price received by producers. The price to
be paid by consumers is P* plus tax (5000 plus 1500). Thus, the new equilibrium price is P3 =
6000 where the new supply curve, S’g and consumer's demand curve, Dg intersect. The price
received by producer is P1 = 4500. Thus, at P1, the price is lower than the original price of P*.
We can conclude that although the tax on gasoline is levied on producers, both consumers and
producers become worse off.
From the perspective of producers, the pain of the 1500 tax is somewhat offset by the fact that
the price received by producers is 1000 more than the initial equilibrium price. Thus, producers
have to pay 500 rupiah of the tax, just the portion that is not offset by price increases. From the
perspective of consumers, the consumer feels some of the pain of the tax since they pay 1000
per liter, although they do not send checks directly to the government. Consumers actually bear
1000 rupiah more than 500 rupiah borne by producers.
The amount borne by consumers is P3 - P*(6000 -5000) = 1000 rupiah. While the amount that
should borne by producers is P*- P2 + tax (5000 - 6000 + 1500) = 500 rupiah. In total, the
amount of tax received by the government is the rectangular region denoted by P1BAP3. By
looking at this simple calculation it can be said that the tax is imposed on the firm but it is the
consumer that actually bears the heavier burden.
 Unit taxes on commodity imposed by Consumers
A commodity tax imposed on consumers (according to the Statutory) is basically equivalent to a
commodity tax on producers as previously described. The only difference is the shift in the
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curve. If consumers have to pay taxes, the consumer demand curve shifts while the supply
curve does not change.
Figure 3.2 shows the incidence of tax gasoline imposed on consumers. At the beginning
equilibrium condition, consumers and producers agree on the price of P* = 5000 with a
quantity of 10. How will the behavior of consumers and producers change as the government
imposes a gasoline tax of Rp 1500 and what part of the tax will be borne by consumers? In
response to a tax, the consumer reduces the amount of gasoline purchased. This is seen
through a shift in the demand curve from Dg to D’g. Before the tax, consumers are willing to
buy gasoline at point E for 10. Now, with the shift to the new demand curve, consumers are
willing to buy 10 at a lower price where P2 = 3500 at point D, as long as they have to pay taxes
for 1500 units of each purchase of gasoline.
At the initial equilibrium price, P*= 5000, there is excess supply; the firm offers a quantity of 9,
while consumers are only willing to buy 8. This implies an excess supply of 1. If the producers
are willing to sell this surplus, they must reduce the price from P* = 5000 to P1 =4500. At this
price, the new equilibrium occurs, where the amount purchased by consumers and sold by the
firm is 9. The market price now at P1= 4500 is lower than the initial equilibrium price, P*= 5000.
Intuitively, the incidence of tax imposed on consumers has two effects in the market; first,
there is a change in the price paid by consumers and the price received by producers, the price
falls from 5000 to 4500. Second, consumers must pay the government 1500 for each liter of
purchase. At the equilibrium price P1 = 4500, an additional tax of 1500 paid by the consumer so
the price paid by consumers is on P3 = 6000, indicated by A, with a quantity of 9. We can also
measure how much tax burden should be borne by consumers. This calculation is done by
taking the new equilibrium price and subtracting the initial equilibrium price plus tax. So P1-P*
+ tax (4500 - 500 + 1500) = 1000 rupiah. In this example, consumers bear 1000 rupiah of the
1500 rupiah gasoline tax. On the other hand the tax burden borne by producers is P *- P1 or
(5000-4500) = 500 rupiah. The amount of taxes collected by the government is 1500 and is
represented by the region P1BAP3.
There are two important conclusions that can be drawn from Figure 3.1 and 3.2 namely: (i)
Producers and consumers are worse off due to tax however, the consumer tax burden greater
than the producers. (ii) Tax does not result in the equitable distribution of income.
Figures 3.1 and 3.2 have two important implications:
1. The incidence of a commodity tax is independent of whether it is imposed on consumers or
producers.
2. The incidence of a commodity tax depends on the elasticity of the supply and demand
curves
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Figure 3.2 Incidence of Tax Unit Imposed to Consumers
Pg
per liter (Rp)
Sg
Consumer
burden= 1000
tax
A
P3=6
E
P*=5
C
B
P1=4.5
Producer
Burden= 500
P2=4
D
Dg
D’g
8
9
Q*=10
Qg
Figure 3.2. Incidence Tax Unit Imposed to Consumers
The Incidence of a tax of commodity is independent of whether is imposed on consumers
or producers
Looking back at Figure 3.1 we can compare between the old equilibrium prices and the new
equilibrium price after the tax has been implemented. After the tax, producers still produce at a
quantity of 10, but the price level, now at P2, is higher. This condition cannot hold as long as
consumers have to pay the price level, P* + tax, at P2. Therefore, producers must shift their
supply curve, S’g. The new supply curve intersects with the demand curve, so that there is a
new equilibrium at point A, with a new quantity of 9. In this case, producers will pay taxes to
the government of (P+tax), but partly of it will be borne by consumers, even if consumers do
not have to directly pay the government (according to the Statutory incidence). The price
received by producers has been lowered. However, because the consumers also bear part of
the burden, the price received by the producers is not by lowered by the full amount of the tax.
A very similar story occurs when the government levies a tax on consumers. If consumers want
to maintain the same amount purchased at pre-tax levels, then they will be willing to buy at the
lower price of P1 (Figure 3.2). However, at this price, the producer must accept a lower price
and producers do not seem to be willing to accept that price. With the tax, consumers will shift
the demand curve down and supply less. This condition occurs at the new equilibrium price
level of P1 and a quantity of 9. The Price level paid by consumers is P3 because of the tax and
the new price received by producers is P1.
The conclusion is that a commodity tax has impact on both consumers and producers; however,
consumers will bear a larger burden than the producers. This proves that the tax does not
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reflect a fair distribution of income. Taxes cause there to be a difference between the price
received by the producers and the price paid by consumers. This is often referred to as the tax
wedge.
Incidence of a tax of Commodity depends on elasticity of supply and demand
Analyzing tax incidence through a geometric approach provides an easier understanding of how
much the tax burden will be borne by consumers and how much will be borne by producers.
The size of the tax burden depends on the elasticity of the demand and supply curves. The
previous Figure shows that the tax burden borne by consumers is greater than that borne by
the producers. This is due to inelastic demand curve. The more inelastic the demand curve, the
greater the burden borne by the consumer, assuming other factors remains constant.
Conversely, the more elastic the demand curve, the less tax burden. Similarly, a more elastic
supply curve will result in a smaller tax burden on producers.
Figure 3.3 Tax Incidences with Perfectly Elastic and Inelastic Supply Curve
P
Pc
P
tax
tax
S
Pc=Po
S
Ps=Po
Ps
D
D
D’
Q2
Q1
D’
Q
Panel A. Perfectly elastic of supply curve
Price paid by consumers
Increases by full the amount of the tax
Consumers bear the entire burden of the tax
Q
Panel B. Perfectly inelastic of supply curve
Price received by producers
falls by full the amount of the tax
Producers bear the entire burden of the tax
Figure 3.3. Tax incidence with perfectly elastic and inelastic of supply curves:
Figure 3.3 Panel A illustrates a tax levied on consumers and a perfectly elastic supply curve. This
implies that consumers will bear the entire burden of the tax. This means that the added tax is
paid entirely by consumers. Before the tax, consumers can buy Q at the price of Ps = Po. After
tax, the consumer demand curve shifts to the left and the quantity purchased drops to Q1. The
price paid by consumers is Pc and the price received by producers is Ps. Thus, if the supply
curve is perfectly elastic, the consumers bear the entire burden of the tax.
In Panel B, the shape of supply curve is perfectly inelastic. When a commodity tax is levied on
consumers, the consumer demand curve shifts to the left, D'. The price received by producers is
the intersection between S and D'. Note that Ps is exactly the same as the amount of taxes
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minus Po. So the price received by producers falls by the size of the tax. However, the price paid
by the consumers remains at Po. In this case, firms bear the entire burden of tax.
Figure 3.3 can also be used to analyze tax incidence when the tax levied on producers. Who will
bear the tax burden? In Panel A, for example, a tax is levied on producers and the producer
supply curve shifts upward by the amount of tax. The equilibrium is achieved at the intersection
of the new supply curve and the initial demand curve (not shown in the figure). The price to be
paid by consumers increases by the amount of the tax. Thus, the entire tax burden is borne by
consumers. Whereas in Panel B, the price paid by the consumers does not change after tax. This
means that the entire tax burden is borne by the firm. This happens because the production
does not depend on the price.
Figure 3.4 Tax incidences with perfectly elastic and
Inelastic demand curves
P
S’
Tax Borned by
producers
Pc=Po
E1
S
Pc
tax
E
P
D
Ps=Po
Tax Borne by
consumers
S’
D
E1
S
tax
E
Ps
Q2
Q1
Q
Panel A. Perfectly elastic demand curve
Price received by producers
falls by full the amount of the tax
producers bear the entire burden of the tax
Q
Panel B. Perfectly inelastic of demand curve
Price paid by consumers
Increases by full the amount of the tax
Consumers bear the entire burden of the tax
Figure 3.4. Tax incidence with perfectly elastic and inelastic demand curves:
Suppose that the shape of the demand curve is perfectly elastic or perfectly inelastic and the
government levies a tax on producers (Figure 3.4). Who should bear the tax burden? Is it
producers or consumers? The answer depends on the shape of the demand curve. Panel A
shows the shape of the demand curve to be perfectly elastic. When there are taxes, the
producer’s supply curve shifts up and becomes S' which intersects the demand curve, D. As a
result, there is a new equilibrium at point E1. Because the demand curve is perfectly elastic, the
consumers do not bear the price increase due to tax. Consumers are not affected at the level of
prices, consumer prices remain at Po. Thus, all taxes due to price increases are borne entirely
by the firm. The price received by producer decreases by the amount of the tax. Panel B shows
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the case where the demand curve is perfectly inelastic. When a commodity tax is levied on
producers and producers face perfectly inelastic demand, the resulting tax will shift the supply
curve upward to S'. There is a new equilibrium at point E1. At point E1, the price paid by
consumers will rise by the amount of the tax. Thus, consumers bear the entire tax if the
demand curve is perfectly inelastic.
Ad Valorem Taxes
The above discussion focused on specific taxes or commodity taxes. Now we discuss ad valorem
taxes. Specific tax is a tax imposed on a given commodities or output. While the ad valorem tax
is a tax imposed as a given percentage of the price. What is the extent of the impact of ad
valorem taxes on equilibrium? Are there similarities or differences in the impact of ad valorem
taxes and the impact of specific taxes?
Suppose the government imposes an ad valorem tax of 20 percent on consumers in the market.
Figure 3.5 shows the ad valorem tax incidence. Pretax equilibrium is characterized by P* and
Q*. Remember that a demand curve lists the maximum price that consumers are willing to pay
for various quantities. So an ad valorem tax vertically lowers the demand curve facing
producers by the amount of the tax. Unlike, a unit tax, however, an ad valorem tax is a
percentage of the sales price, and therefore the demand curve does not shift down in a parallel
manner.
For example, at an initial price of 2000 per unit, the after tax price received by producers would
be 1600. At an initial price of 200, the after tax price would be 160. This logic plots out D’ as the
new demand curve facing firms and, as shown in Figure 3.5, the vertical distance between D
and D’ falls as price falls.
Point E1 is the after tax equilibrium, at the intersection of the after tax demand curve D' and
the supply curve. The price received by producers is P1 and the price paid by consumers is P2.
P1P2 reflects the ad valorem tax. The burden imposed on producers is P1P*, and for consumers
it is P*P2. Thus, the ad valorem tax and specific tax have the same effect. Level of output sold,
tax revenues, price paid by consumer and price received by producers are all the same.
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Figure 3.5 Incidence Tax Ad Valorem
P
2000
S
1600
P2
E
P*
Before Tax
P1
E1
Ad Valorem Tax
200
160
D
D’
Q1 Q*
Q
Figure 3.5. Incidence Tax Ad valorem
Tax incidence with Imperfect Competition
Taxation effects depend on market structure. The two most extreme market structures are
perfect competition and imperfect competition. We consider monopoly as an example of
imperfect competition. The imposition of taxes on firms that face the market structure of
imperfect competition such as monopolist has a different impact on prices, tax revenues and
output. The question is how big of an impact will taxes have on the firms when firms face
imperfect competition market as opposed to when they face perfect competition? Figure 3.6
shows the initial equilibrium before the tax. The demand curve faced by a monopolist is D. The
marginal revenue curve is MR. The MR curve lies below the demand curve and shows the extra
revenue received by the firm from selling an extra unit of output. In this case, the firm chooses
the amount of output Q*, where marginal cost and marginal revenue intersect. Recall that a
monopolist reaches a maximum profit when MR = MC. Because the monopolist is a price taker,
the monopolist sets the price along the consumer demand curve. At a price of Pm, the amount
of output sold is Q1, so the total profit of the monopolist is the area of rectangle, PCAPm.
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Figure 3.6 Equilibrium of a Monopolist before tax
P
Pm
P
Economic
Profits
A
MC
ATC
C
D
MR
Q1
Q*
Q
Figure 3.6. Equilibrium of a Monopolist before tax
Now suppose that government imposes a unit tax on the commodity. What is the impact on the
monopolist? The explanation is similar to that of a perfectly competitive market in that the
demand curve faced by the monopolist shifts down by the amount of the tax, D1. The
downward shift in the consumer demand curve results in a decrease in additional revenue
received by the marginal revenue curve shifting downward to MR1. The marginal cost curve
and average total cost curve also shift upwards because firms’ costs increase after the tax.
These are labeled MC1 and ATC1, respectively (Figure 3.7). Many references such as Gruber
(2005), Stiglitz (2000) and Rosen (2008) do not show the shift upwards of the marginal cost
curve (MC) and the shift downward of the marginal revenue, (MR). The reason is that the final
outcomes are identical. Now, however, the MC and MR shift is associated with the change of
the monopolist’s situation. This is to make it easier for the reader to understand. The
intersection between MR1 and MC1 is a necessary condition for maximum profit. The price
received by the monopolist after tax is Pm1. The total average cost for output Q1 is the distance
de. Thus, economic profit for a monopolist is a rectangle area, Pm1def (green color).This is the
difference between the price received by the monopolist, Pm1 and the average cost per unit of
output sold, de. The conclusion is (1) after tax, output Q1 <Q*, (2) the price paid by consumer
goes up from Pm to Pc, (3) the price received by monopolist goes down from Pm to Pm1, (4)
Economic Profit for monopolist goes down from PmACf (orange color) to Pm1def (green color).
In the case of imperfect competition such as a monopoly, the tax effect depends on the shape
of the demand curve. The same thing can be done with ad valorem taxes to the monopolist.
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Figure 3.7 Incidence Unit Tax on Monopolist
P
MC1
G
Pc
A
Pm
After
tax
f
d
e
ATC1
Before tax
Pm1
C
tax
MR1 MR
Q1
D
D1
Q*
Q
Figure 3.7. Incidence a unit tax on Monopolist
3.4. General Equilibrium Model of tax incidence
Tax incidence analysis using a partial equilibrium model, seems not to give a perfect analysis of tax
incidence. A partial equilibrium model focuses only on one market. A partial equilibrium model
assumed that the output produced is very small firms in comparison with the overall output. Thus, if
there is a reduction in output due to the tax, the other firm did not share in the impact the tax. In many
cases, firms are interdependent, so that if one of them is disrupted by a government policy such as a
unit tax, then other companies would also be disrupted. More generally, when a tax imposed on a
“large sector” relative to the economy, looking at only one particular market may not be enough. In
this case, general equilibrium analysis takes into account the ways in which various markets are
interrelated.
Rosen (2008) discusses some of the weaknesses that are found by using partial equilibrium analysis; (i)
because it only focuses on one market, it ignores other market feedback. For example consider the
reduction in cigarette sales due to a tax. The tax causes farmers to not plant tobacco and they divert to
other crops such as cotton. As a result, the cotton supply increases, prices fall and so on, eventually
farmers who previously grew cotton share the burden of the cigarette tax. (ii) The partial equilibrium
model produces insufficient information when it only focuses on the question of how the producer of a
commodity is taxed.
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To better understand let us illustrate through Figure 3.8 A and B. It is assumed that there are only two
output markets in the economy, a market for electric fans and a market for chairs. These two outputs
are interdependent. Figure 3.8A shows initial equilibrium by P* and Q*, the intersection of supply, Sf
and Df. Now consider how a unit tax on producers of fans affects resource allocation in the market for
fans. A unit tax, T causes a parallel shift in the supply curve to Sf + tax. This increases the equilibrium
price to P'f and decreases the quantity to Q1. So far this analysis is no difference than before,. In this
case, the price paid by the consumer is, P'f and the price received by producers is P1. So, the
consumers bear the tax burden, P* P'f and producers bear the burden tax, P1P*. This is similar partial
equilibrium model. However, the analysis becomes more complex if the electric fan market is
associated with other markets, such as the chair market. If the resource has high mobility, a decline in
market supply electric fan causes more resources to be diverts to the output of chairs. Resources
previously used to produce the fan are no longer used and they transferred to chair output. Figure 3.8B
shows the movement of the supply curve down to S'C. The intersection of the new supply curve and
demand curve produces a new equilibrium, P1Q1, previously shown by P*Q*.Chair output increases
and the output of electric fan decreases.
Figure 3.8A Tax Incidence of General Equilibrium Model
P Fan
S’f+Tax
Sf
P’f
A
E
P*f
P1
B
Df
Q1
Q*
Qf
Figure 3.8.A Tax Incidence with General Equilibrium Model
By using a general equilibrium model, the outputs of chairs and electric fans affect input markets and
other markets as well. What will happen in others market? For example, the labor market for electric
fans and the labor market for the chairs. In addition, the market for other inputs used to produce
electric chairs and fans are also affected.
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A general equilibrium model is relatively easy to understand in a world with two goods in which taxes
are imposed only in one market. However, a unit tax may be imposed on both the fan market and also
on the chair market at the same time. When the tax is imposed at the same time, it may be expected
that resources will not shift as much as in the case in which a tax is imposed on only one market. If we
extend the analysis past the two good cases to a case where hundreds or thousands of goods are
produced, then the general equilibrium model becomes more complex. If we do not carefully analyze
how the tax affects all markets then tax policy may ultimately be inefficient.
Many empirical studies estimate the impact of a tax policy on the economy, by using general
equilibrium model (see for example; Baldacci, E., Cangiano, M., Mahfouz, S., and Schimmelpfennig, A.
2001; Chakraborty, L.S., 2001; Blomquist, Eklof, and Newey, 2001; Benos, , 2004). They concluded that
the taxes effect on income distribution depends on the political and economic conditions of the
country.
Figure 3.8 B Tax Incidences of General Equilibrium Model for Other Market
P Chair
Sc
S’c
E
P*
P’c
A
Dc
Q*
Q1
Qc
Figure 3.8.B Tax Incidence with General Equilibrium Model for other Market
The imposition of taxes both the consumer and the producer must be done carefully. Taxes policy is
not always able to generate economic efficiency so that the income is not distributed properly. Horioka
and Sekita (2007) conducted a analysis of personal taxes (defined to include consumption and income
taxes), found that the structure of Japan’s current consumption and income taxes was problematic
from the viewpoints of both efficiency and equity and propose a reform package that improves both
the efficiency and equity of Japan’s personal taxes and, at the same time, achieves fiscal
reconstruction. This finding, however, contradicted the finding by Bye and Avitsland (2003) for the case
of tax reform in Norwegia. Bye and Avitsland analyzed the welfare effects of imposing a neutral system
of housing taxation by using an intertemporal general equilibrium model (CGM) for the Norwegian
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economy. They found that the tax reform implies a substantial increase in the tax revenue from
housing taxation.
The imposition of taxes to the producer can affect other economic variables such as labor hours, labor
income, tax revenue, income distribution and investment. The tax system generates inefficiency in the
labor market through both direct and indirect labor income taxation (Bye and Avitsland, 2003). The US
Tax Reform of 1986 increased the intertemporal non-neutrality of the tax system, but this negative
contribution to welfare was more than outweighed by the intertemporal efficiency gain of leveling the
capital tax rates and reducing the labor income tax (Goulder and Thalmann 1993). Blomquist, Eklof,
and Newey (2001) evaluated the tax reform carried out in Sweden between 1980 and 1991. They used
a recently developed non-parametric estimation technique to account for the labor supply responses
of married prime aged males. They decomposed the tax reform to study how the separate components
influence hours of work, tax revenue, and income distribution. They found that the decrease in
marginal tax rates stimulated labor supply. The net increase in average desired hours of work was
approximately 2%. They also found that the reform was under financed and that inequality increased.
The recent study regards to tax incidence conducted by Wahid and Wallace (2008) and Sennoga,
Sjoquist, and Wallace (2008). Wahid and Wallace (2008) found that all households bear part of the
burden of taxes in Pakistan, the higher income of households bear a larger share of the burden than
low-income households. Taxes on capital would generally increase the tax burden on the higher
income groups. In addition, they noted that changes in any tax (such as corporate income tax) can have
impacts throughout the income distribution. Sennoga, Sjoquist, and Wallace (2008) developed a
computable general equilibrium model (CGE) and tested the impact of various assumptions regarding
specific issues that reflect the reality of property taxes in transition and developing countries. They
pointed that the burden of property taxes imposed on capital and land is borne by the owners of land
and capital and is not significantly influenced by the assumptions regarding the mobility of capital.
From their analysis it appears that property tax is a vehicle for introducing some progressivity into the
revenue structure of developing and transition countries.
Capital income tax reductions are often used to stimulate economic activity during business downturns
or to promote economic growth. In general, lowering capital income tax rates improves the after– rate
of return of investment and facilitates capital accumulation. A higher capital stock, in turn, raises the
marginal product of labor and the real wage. Consequently, it is often argued that capital income tax
reductions have trickle–down effects because labor also benefits from a higher income. However, in
the empirical study, capital income tax reduction did not create the trickle-down effects it depends on
how government manages debt to maintain budget solvency (Shu-Chun Susan, 2007).
Doing a tax cut for income distribution objectives in principle has two important implications: the
financing of the tax changes, and the implications of behavioral responses for economic growth,
incomes, and well-being. A tax cut can made some people are better off, especially for high-income
households and most of the others are made worse off, especially in the lower three income quintiles
(Douglas W.Elmendorf, Jason; Furman, William G; Gale and Benjamin H; Harris (2008).
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