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TAXATION AND INCOME DISTRIBUTION Chapter 14 Vocabulary • • • • Statutory Incidence Economic Incidence Tax Shifting Partial Equilibrium Models 14-2 Tax Incidence: General Remarks • Only people can bear taxes – Functional distribution of income – Size distribution of income • Both sources and uses of income should be considered • Incidence depends on how prices are determined • Incidence depends on the disposition of tax revenues – Balanced-Budget tax incidence – Differential tax incidence – Lump-sum tax – Absolute tax incidence 14-3 Tax Progressiveness Can Be Measured in Several Ways • Average tax rate versus marginal tax rate • Proportional tax system • Progressive tax system • Regressive tax system Tax Liabilities under a hypothetical tax system Income Tax Average Marginal Liability Tax Rate Tax Rate $2,000 -$200 -0.10 0.2 3,000 0 0 0.2 5,000 400 0.08 0.2 10,000 1,400 0.14 0.2 30,000 5,400 0.18 0.2 14-4 Measuring How Progressive a Tax System Is v1 T1 I1 I1 I 0 T0 I0 v2 T1 T0 T0 I1 I 0 I0 14-5 Measuring How Progressive a Tax System is – A Numerical Example v1 T1 I1 T0 I0 v2 I1 I 0 .00025 1000 800 300 1000 200 800 .0003 1000 800 360 1000 240 800 T1 T0 T0 I1 I 0 I0 2.0 300 200 200 1000 800 800 2.0 360 240 240 1000 800 800 14-6 Partial Equilibrium Models • Models that study only one market and ignore possible spillover effects on other markets • Economic incidence depends on: – Elasticities of Supply and Demand – Tax Salience: the extent to which a tax rate is made prominent to a taxpayer • Economic incidence does not depend on whether it is levied on Consumers or Producers. 14-7 Price Unit Tax on Commodities 2.60 2.40 S1 2.20 Before Tax After Tax 2.00 S0 1.80 Consumers Pay $1.20 $1.40 1.60 1.40 1.20 Suppliers Receive $1.20 $1.00 1.00 0.80 D0 0.60 0 1 2 3 4 5 D1 6 7 8 Quantity 14-8 Price 2.6 SX 2.4 Perfectly Inelastic Supply 2.2 2 S 1.8 1.6 1.4 1.2 1 0.8 0.6 0 1 2 3 4 5 DX’ DX 6 7 Quantity 8 14-9 Price 2.6 2.4 2.2 2 S 1.8 Perfectly Elastic Supply 1.6 1.4 SX 1.2 1 0.8 DX 0.6 0 1 2 3 4 5 DX’ 6 7 Quantity 8 14-10 Price per Pound of food Ad Valorem Taxes Sf Pr P0 Pm Df Qr Q0 Qm Df ’ Pounds of food per year 14-11 Taxes on Factors Statutory vs. Economic Incidence • The Payroll Tax – Tax on labor that finances Social Security • Tax on Capital in a Global Economy 14-12 Wage rate per hour The Payroll Tax SL Pr wg = w0 wn DL’ L0 = L 1 DL Hours per year 14-13 Commodity Taxation without Competition • Monopoly – Despite market power a monopolist is generally made worse off • • • • QD does down Price paid by consumers goes up Price received by the monopolist goes down Profits go down • Oligopoly – Can result in higher or lower profits 14-14 Monopoly $ Economic Profits MXX c P0 Economic Pn i Profits dh after unit tax ATC0 a f g ATCX b DX MRX X1 X 0 MRX’ DX’ X per year 14-15 Profits Taxes • • • • Economic profit Perfect competition Monopoly Measuring economic profit 14-16 Tax Incidence and Capitalization • PR = $R0 + $R1/(1 + r) + $R2/(1 + r)2 + … + $RT/(1 + r)T • PR' = $(R0 – u0) + $(R1 – u1)/(1 + r) + $(R2 – u2)/(1 + r)2 + … + $(RT – uT)/(1 + r) • u0 + u1/(1 + r) + u2/(1 + r)2 + … + uT/(1 + r)T • Capitalization: A stream of tax liabilities becomes incorporated into the price of an asset 14-17 General Equilibrium Models • Show how various markets are interrelated • Consider a 2-commodity, 2-factor economy resulting in the following 9 possible ad valorem taxes tKF = a tax on capital used in the production of food tKM = a tax on capital used in the production of manufactures tLF = a tax on labor used in the production of food tLM = a tax on labor used in the production of manufactures tF = a tax on the consumption of food tM = a tax on consumption of manufactures tK = a tax on capital in both sectors tL = a tax on labor in both sectors t = a general income tax 14-18 Tax Equivalence Relations • Partial factor tax: tax levied on an input in only some of its uses. – tKF, tLF, tKM, tLM • Tax Equivalence: any two sets of taxes that generate the same changes in relative prices. tKF and and tKM tLF are equivalent to and and tLM tF and are equivalent to tM are are are equivalent equivalent equivalent to to to tK and tL are equivalent to t Source: McLure [1971]. 14-19 The Harberger Model • Assumptions – Technology • Elasticity of substitution • Capital intensive • Labor intensive – – – – – Behavior of factor suppliers Market structure Total factor supplies Consumer preferences Tax incidence framework 14-20 Analysis of Various Taxes • • • • Commodity tax (tF) Income tax (t) General tax on labor (tL) Partial factor tax (tKM) – Output effect – Factor substitution effect 14-21 Some Qualifications • Differences in individuals’ tastes • Immobile factors • Variable factor supplies 14-22 An Applied Incidence Study Average Federal Tax Rates and Share of Federal Taxes by Income Quintile (2009) Income Category Average Federal Tax Rate Lowest Quintile 1.0% Second Quintile 6.8% Third Quintile 11.1% Fourth Quintile 15.1% Highest Quintile 23.2% All Quintiles 17.4% Top 1% 28.9% Source: Congressional Budget Office (2012a) Share of Federal Taxes 0.3% 3.8% 9.4% 18.3% 67.9% 100.0% 22.3% 14-23 Chapter 14 Summary • Who bears the burden of a tax? It depends on price changes, which, in turn, depend on: – – – – – – Time frame Disposition of tax revenue Market structure Elasticities of supply and demand Mobility of factors of production Tax salience • Partial equilibrium incidence and general equilibrium incidence analyses are used to determine burdens of unit and ad-valorem taxes 14-24