TAX INCIDENCE AND THE BURDEN OF A TAX

  1. EXCISE TAX – per unit bought or sold; for example, tire disposal tax
  2. AD VALOREM TAX
    1. "SALES" TAX – the value of the "cash register tape" (taxable items)
    2. PROPERTY TAX – the assessed value of the property to be taxed at the millage rate
  3. PAYROLL TAX

Social Security tax –     6.20 percent
Medicare tax  –             1.45 percent
Total                               7.65 percent, employee and employer each

GRAPHICAL EXAMPLE

P 1 – what the buyer pays and what the seller receives and keeps before the tax

P2 – what the buyer pays and seller receives after the tax is imposed

P3 – what the seller keeps after the tax

Buyer’s portion of the tax: P2 – P1

Seller’s portion of the tax: P1 – P3

Total tax: P2 – P3

The author presents his analysis in two different (but equivalent) ways:

Case 1: Assess tax against seller (seller remits tax): SS curve shifts up
Case 2: Assess tax against buyer (buyer remits tax): DD curve shifts down

But we find that: It doesn’t matter who pays the tax. The division of the burden is the same, and is determined by relative elasticities of demand and of supply. The question of tax incidence is not who pays but who bears the burden of the tax. Sometimes government will attempt to mandate the division of a tax (as with the Social Security payroll tax), but even government cannot revoke the "Laws of Supply and Demand."

Arrange your graphs like this:

Inelastic Demand Elastic Supply
Buyer bears most of tax
Elastic Demand Inelastic Supply
Seller bears most of tax

Remember:

  1. Elastic demand means the buyer is price resistant; raise the price on the buyer and a lot of them will leave the market; so it is difficult to pass through the tax to them.
  2. Inelastic demand means the buyer is not very price resistant: buyers will accept a price hike and relatively few will leave the market; so it is easier to pass through the tax to them.
  3. Elastic supply means that the seller is price resistant: lower the price and a lot of sellers will leave the market; so it is difficult to get them to absorb the tax through a price decrease.
  4. Inelastic supply means that the seller is not particularly price resistant: a lower price will not cause many of them to leave the market; so it is easier to pass through a tax to them by getting them to absorb the tax in the form of lower prices.

EXAMPLES:

So, when the market displays both inelastic demand and elastic supply, for example, the burden is shifted to the buyer even more than if the market displays inelastic demand but not particularly elastic supply.

Or, when the market displays both elastic demand and inelastic supply, the burden is shifted to the seller even more than if the market displays inelastic supply but not particularly elastic demand.

And you can come up with other combinations of these cases. In addition, what would be true if the demand were "perfectly inelastic" with normal supply? Or if supply were "perfectly inelastic" with normal demand? Of if demand were "perfectly elastic" with normal supply? Or if supply were "perfectly elastic" with normal demand?

Finally, the "Tax Wedge" (the difference between what price the buyer pays and what the seller gets to keep) suppresses economic activity (production of goods, hiring of labor, and so forth). Any tax distorts the market because it pushes the market away from what its equilibrium would otherwise be. This assertion is as true for a "sales" tax or a "payroll" tax as it is for an excise tax.

Class Notes | Clint Johnson |  Economics & Finance | Departments & Majors
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