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Does Congress decide who pays
the taxes?
© 2013 Pearson
8
Taxes
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Explain how taxes change prices and quantities, are
shared by buyers and sellers, and create inefficiency.
2 Explain how income taxes and Social Security taxes
change wage rates and employment, are shared by
employers and workers, and create inefficiency.
3 Review ideas about the fairness of the tax system.
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8.1 TAXES ON BUYERS AND SELLERS
Tax Incidence
Tax incidence is the division of the burden of a tax
between the buyer and the seller.
When a good is taxed, it has two prices:
• A price that includes the tax
• A price that excludes the tax
Buyers respond to the price that includes the tax.
Sellers respond to the price that excludes the tax.
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8.1 TAXES ON BUYERS AND SELLERS
The tax is like a wedge between the two prices.
Suppose that the government puts a $10 tax on MP3
players.
How does the price paid by the buyer change?
How does the price received by the seller change?
How is the burden of a tax shared between the buyer
and the seller?
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8.1 TAXES ON BUYERS AND SELLERS
Figure 8.1(a) shows what
happens when the
government taxes buyers
of the MP3 players.
1. With no tax, the price
is $100 and 5,000
players are bought.
2. A $10 tax on buyers
shifts the demand curve
to D – tax.
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8.1 TAXES ON BUYERS AND SELLERS
3. The buyer’s price rises
to $105—an increase
of $5 a player.
4. The seller’s price falls
to $95—a decrease of
$5 a player.
5. The quantity decreases
to 2,000 players a week.
6. The government’s tax
revenue is $20,000.
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8.1 TAXES ON BUYERS AND SELLERS
Figure 8.1(b) shows what
happens when the
government taxes sellers
of the MP3 players.
1. With no tax, the price is
$100 and 5,000 players
a week are bought.
2. A $10 tax on sellers of
MP3 players shifts the
supply curve to S + tax.
© 2013 Pearson
8.1 TAXES ON BUYERS AND SELLERS
3. The buyer’s price rises
to $105—an increase
of $5 a player.
4. The seller’s price falls
to $95—a decrease
of $5 a player.
5. The quantity decreases
to 2,000 players a
week.
6. The government’s tax
revenue is $20,000.
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8.1 TAXES ON BUYERS AND SELLERS
Taxes and Efficiency
A tax places a wedge between the buyers’ price
(marginal benefit) and the sellers’ price (marginal cost).
The equilibrium quantity is less than the efficient
quantity and a deadweight loss arises.
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8.1 TAXES ON BUYERS AND SELLERS
Figure 8.2 shows the
inefficiency of taxes.
In Figure 8.2(a), the market is
efficient with marginal benefit
equal to marginal cost.
Total surplus—the sum of
2. Consumer surplus and
3. Producer surplus—is
maximized.
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8.1 TAXES ON BUYERS AND SELLERS
Figure 8.2(b) shows how
taxes create inefficiency.
A $10 tax shifts the supply
curve to S + tax.
1. Marginal benefit exceeds
2. Marginal cost.
3. Consumer surplus and
4. Producer surplus shrink.
5. The government collects
its tax revenue.
6. A deadweight loss arises.
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8.1 TAXES ON BUYERS AND SELLERS
The loss of consumer
surplus and producer
surplus is the burden of
the tax.
The burden of the tax
equals the tax revenue
plus the deadweight
loss.
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8.1 TAXES ON BUYERS AND SELLERS
Excess burden is the
deadweight loss from a
tax.
The excess burden is
(3,000  $10  2), which
equals $15,000.
Excess burden is the
amount by which the
burden of a tax exceeds
the tax revenue received
by the government.
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8.1 TAXES ON BUYERS AND SELLERS
 Incidence, Inefficiency, and Elasticity
The incidence of a tax and its excess burden depend on
the elasticites of demand and supply:
• For a given elasticity of supply, the buyer pays a
larger share of the tax, the more inelastic is the
demand for the good.
• For a given elasticity of demand, the seller pays a
larger share of the tax, the more inelastic is the
supply of the good.
• Excess burden is smaller, the more inelastic is
demand or supply.
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8.1 TAXES ON BUYERS AND SELLERS
Incidence, Inefficiency, and Elasticity of
Demand
Perfectly Inelastic Demand: Buyer Pays and Efficient
Perfectly Elastic Demand: Seller Pays and Inefficient
Figures 8.3(a) and 8.3(b) illustrate these two extreme
cases.
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8.1 TAXES ON BUYERS AND SELLERS
Figure 8.3(a) shows tax
incidence in a market with
perfectly inelastic demand—
the market for insulin.
A tax of 20¢ a dose raises the
price by 20¢, and the buyer
pays all the tax.
Marginal benefit equals
marginal cost, so the outcome
is efficient.
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8.1 TAXES ON BUYERS AND SELLERS
Figure 8.3(b) shows tax
incidence in a market with
perfectly elastic demand—
the market for pink pens.
A tax of 10¢ a pink pen
lowers the price received by
the seller by 10¢, and the
seller pays all the tax.
A deadweight loss arises, so
the outcome is inefficient.
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8.1 TAXES ON BUYERS AND SELLERS
Incidence, Inefficiency, and Elasticity of
Supply
Perfectly Inelastic Supply: Seller Pays and Efficient
Perfectly Elastic Supply: Buyer Pays and Inefficient
Figures 8.4(a) and 8.4(b) illustrate these two extreme
cases.
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8.1 TAXES ON BUYERS AND SELLERS
Figure 8.4(a) shows tax
incidence in a market with
perfectly inelastic supply—the
market for spring water.
A tax of 5¢ a bottle does not
change the price paid by the
buyer but lowers the price
received by the seller by 5¢.
Marginal benefit equals
marginal cost, so the outcome
is efficient.
The seller pays the entire tax.
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8.1 TAXES ON BUYERS AND SELLERS
Figure 8.4(b) shows tax
incidence in a market with
perfectly elastic supply—the
market for sand.
A tax of 1¢ a pound
increases the price by 1¢ a
pound, and the buyer pays
all the tax.
A deadweight loss arises, so
the outcome is inefficient.
© 2013 Pearson
8.2 INCOME TAX AND SOCIAL SECURITY TAX
The Personal Income Tax
In 2009, the personal income tax raised:
• $1.25 trillion for the federal government
• About $300 billion for state and local governments
The amount of income tax that a person pays depends
on her or his taxable income and on the tax rates.
Taxable income is total income minus a personal
exemption and a standard deduction (or other allowable
deductions).
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
Marginal tax rate is the percentage of an additional
dollar of income that is paid in tax.
Average tax rate is the percentage of income that is
paid in tax.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
A tax can be progressive, proportional, or regressive.
A progressive tax is a tax whose average rate
increases as income increases.
A proportional tax is a tax whose average rate is
constant at all income levels.
A regressive tax is a tax whose average rate
decreases as income increases.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
Figure 8.5 shows
U.S. tax rates in
2011.
1. Marginal tax
rate increases
with income.
2. Average tax
rate increases
with income.
The personal
income tax is a
progressive tax.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
The Effects of the Income Tax
Tax on Labor Income
Firms can substitute machines for labor, so the demand
for labor is elastic.
Most people must work for their income, so the supply
of labor is inelastic.
With elastic demand and inelastic supply, the worker
bears the greater burden of the income tax.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
Figure 8.6 shows the effects
of a tax on labor income.
1. Workers pay a 20 percent
marginal income tax rate.
The supply of labor
decreases.
The wage rate rises, and the
after-tax wage rate falls.
2. The employer pays some
of the tax.
3. The worker pays most of
the tax.
4. A deadweight loss arises.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
Taxes on Capital Income
Taxing the income from capital works like taxing the
income from labor.
One crucial difference: capital is internationally mobile
and so the supply of capital is highly elastic—perhaps
perfectly elastic.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
Figure 8.7 shows the effect of
a tax on capital income.
1. The supply of capital is
perfectly elastic.
2. With a 40 percent tax on
capital income, the interest
rate rises.
3. The firm pays the entire tax.
4. A large deadweight loss
arises.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
Taxes on Income from Land and Unique Resources
Works in the same way as taxing the income from other
sources except for one crucial difference.
The supply of land is highly inelastic.
The tax on land income is fully borne by the landowners
and the quantity of land is unaffected by the tax.
With no change in the quantity of land, the tax on land
income creates no deadweight loss or excess burden and
is efficient.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
Figure 8.8(a) shows a tax
on income from land.
1. Supply is perfectly inelastic.
2. With a 40 percent tax, the
supply of land is unchanged
and the market rent is
unchanged.
3. The landowner pays the
entire tax.
No deadweight loss arises—
the tax is efficient.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
Figure 8.8(b) shows a high tax
rate on Angelina’s income.
1. Supply is perfectly inelastic.
2. With a 40 percent tax, the
supply curve is unchanged
and the market price is
unchanged.
3. Angelina pays the entire tax.
No deadweight loss arises
and the tax is efficient.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
The Social Security Tax
The Social Security tax law says that the tax is to be
shared equally by workers and employers.
But the principles that determine the incidence of other
taxes you’ve studied in this chapter also apply to the
Social Security tax.
We look at two extreme Social Security taxes: one on
workers only and one on employers only.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
A Social Security Tax
on Workers
With no taxes, the wage
rate is $12.00 an hour
and 4,000 people are
employed.
1. A 20 percent Social
Security tax on workers
shifts the supply curve
to LS + tax.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
2. The wage rate paid by
employers rises to
$12.50 an hour—an
increase of 50¢ an
hour.
3. The number of people
employed decreases
to 3,000.
4. Workers receive $10.00
an hour—a decrease
of $2 an hour.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
5. The government collects
tax revenue shown by
the purple rectangle.
Workers pay most of the
tax because the supply
of labor is more inelastic
than the demand for
labor.
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8.2 INCOME AND SOCIAL SECURITY TAX
A Social Security Tax on Employers
Payroll tax is a tax on employers based on the wages
they pay their workers.
Figure 8.10 on the next slide shows the effects of a
payroll tax.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
A Social Security Tax
on Employers
With no tax, the wage
rate is $12.00 an hour
and 4,000 people are
employed.
1. A tax on employers of
$2.50 an hour shifts
the demand curve to
LD – tax.
© 2013 Pearson
8.2 INCOME TAX AND SOCIAL SECURITY TAX
2. The wage rate falls
to $10.00 an hour—
a decrease of $2.00
an hour.
3. The number of
workers employed
decreases to 3,000.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
4. Employers’ total cost
of labor rises to
$12.50 an hour—the
$10.00 wage rate
plus the $2.50 tax.
5. The government
collects tax
revenue shown by
the purple
rectangle.
© 2013 Pearson
8.3
FAIRNESS AND THE BIG TRADEOFF
Whenever political leaders debate tax issues, it is
fairness, not efficiency, that looms above all other
considerations.
There are two conflicting principles of fairness of taxes:
• The benefits principle
• The ability-to-pay principle
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8.3
FAIRNESS AND THE BIG TRADEOFF
The Benefits Principle
The benefits principle is the proposition that people
should pay taxes equal to the benefits they receive from
public goods and services.
This arrangement is fair because it means that those
who benefit most pay the most.
But to implement it, we would need an objective way of
measuring each person’s marginal benefit from public
goods and services.
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8.3
FAIRNESS AND THE BIG TRADEOFF
The Ability-to-Pay Principle
The ability-to-pay principle is the proposition that
people should pay taxes according to how easily they
can bear the burden.
A rich person can more easily bear the burden of
providing public goods than a poor person can, so the
rich should pay higher taxes than the poor.
This principle compares people according to
• Horizontal equity
• Vertical equity
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8.3
FAIRNESS AND THE BIG TRADEOFF
Horizontal equity is the requirement that taxpayers
with the same ability to pay should pay the same taxes.
Vertical equity is the requirement that taxpayers with
a greater ability to pay bear a greater share of the
taxes.
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8.3
FAIRNESS AND THE BIG TRADEOFF
The Marriage Tax Problem
• In the U.S. tax code, a married couple is considered a
single taxpayer.
• This arrangement means that if they each earn the
same income as before a marriage, the married
couple might pay more tax than they did before
marriage.
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8.3
FAIRNESS AND THE BIG TRADEOFF
The Big Tradeoff
Questions about the fairness of taxes conflict with
efficiency questions and create the big tradeoff.
Taxes on capital incomes create the greatest
deadweight loss—are the most inefficient.
But most of the capital is owned by a small number of
rich people, so (most people believe) taxes on capital
are the fairest.
Our tax system is an evolving attempt to juggle the two
goals of efficiency and fairness.
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Does Congress Decide Who Pays the Taxes?
Congress says that employers and workers pay the same
Social Security tax contributions (7.65 percent each in
2011).
But because the elasticity of demand for labor is much
greater than the elasticity of supply of labor, workers end
up paying most of the Social Security tax.
But there is one thing that Congress can do to influence
who pays a tax.
It can pass a tax law (or tax rebate law) that doesn’t
impact the margin on which decisions turn.
Recently, Congress passed such a law.
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Does Congress Decide Who Pays the Taxes?
On February 17, 2009, the President signed the
American Recovery and Reinvestment Act.
Among the Act’s many provisions is a “Making Work Pay”
tax credit of $400 for a single worker and $800 for a
couple.
A tax credit is a fixed reduction in the amount paid in
personal income tax (in the current case, $400).
For most people, a tax credit has no effect on their supply
of labor.
The tax credit doesn’t influence the work-hours choice.
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Does Congress Decide Who Pays the Taxes?
A 20% income tax rate shifts
the labor supply curve from
LS to LS + tax.
The pre-tax wage rises
by $1 to $20 per hour,
the after-tax wage falls by
$3 to $16 per hour, and
the workweek fall from
40 hours to 35 hours.
Workers pay 75% of the tax
and employers pay 25%.
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Does Congress Decide Who Pays the Taxes?
Suppose that Congress
now passes an Act that
gives workers a tax rebate
of $30 a week.
Tax paid by worker falls.
Marginal tax rate remains
at 20%, but now workers
pay only 68% of the tax
and employers pay 32%.
Congress has worked
around the elasticities!
© 2013 Pearson