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Economics for your Classroom
Ed Dolan’s Econ Blog
Who Really Pays Taxes?
The Question of Tax Incidence
June 21, 2014
Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free
to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like
the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.
Who Really Pays Taxes?
 Governments have been collecting taxes
since the dawn of history, but there is still
confusion over who really pays them
 The question of tax assessment tells us
who bears the legal responsibility for paying
a given tax.
 The question of tax incidence tells us who
bears the economic burden of a tax
 This slideshow will explain why the answers
to these two questions are not the same
June 21, 2014 Ed Dolan’s Econ Blog
Sign on an abandoned
gasoline pump:
29.9 cents per gallon, all
taxes included
Example 1: A gasoline tax
 Suppose that in the state of
Virginia, there is initially no
gasoline tax
 The gasoline market is in
equilibrium at point E1, where the
price is $2 per gallon and the
quantity sold is 10 million gallons
per day
June 21, 2014 Ed Dolan’s Econ Blog
Elasticity of Supply and Demand
 The elasticity of supply and
demand will play an important part
in our story
 Elasticity means the percentage
change in quantity associated with
a 1 percent change in price
 Notice that in the neighborhood of
the equilibrium point, supply is
more elastic than demand, that is,
a 1 percent change in price would
cause a larger percentage change
in the quantity supplied than in the
quantity demanded
June 21, 2014 Ed Dolan’s Econ Blog
Effect of a $1 per Gallon Tax on the Supply Curve
 Now suppose the state imposes a
$1 per gallon tax
 Sellers will be willing to supply the
same quantity as before only if
they can raise the price including
tax by $1
 That means the tax-inclusive
supply curve shifts upward by $1,
from S1 to S2
 The old supply curve S1 shows
what is left for sellers after the tax
is paid
June 21, 2014 Ed Dolan’s Econ Blog
Effects of a $1 per Gallon Tax on Quantity Supplied and Demanded
 The tax will affect the choices
made by buyers as well as sellers
 As sellers attempt to pass the tax
along, consumers will move up
and to the left along the demand
curve, reducing the quantity
demanded
 As buyers purchase less gasoline,
sellers will move down and to the
left along S1
June 21, 2014 Ed Dolan’s Econ Blog
New Equilibrium After the Tax
 Consumers will continue to move
along their demand curve until they
reach point E2, where the quantity
demanded at the price including
tax equals the quantity supplied
 In the new equilibrium, the price,
including tax, will be $2.80 and the
quantity will fall to 8 million gallons
per day
 The price received by sellers, after
the tax is paid, will fall to $1.80
June 21, 2014 Ed Dolan’s Econ Blog
Incidence of the Gasoline Tax
 In the new equilibrium, total tax
revenue will be $8 million per day,
equal to the area of the entire
shaded rectangle ABFE
 Consumers will bear 80% of the
burden ($6.4 million), equal to the
blue shaded area ABDC, because
the price they pay including tax
has gone up by 80 cents
 Sellers will bear 20% of the burden
($1.6 million), equal to the tan area
CDFE, because the price they
receive after the tax is paid goes
down by 20 cents
June 21, 2014 Ed Dolan’s Econ Blog
Example 2: A tax on apartment rents
 For our second example,
consider the market for rental
apartments in a small city
 In equilibrium 2,000 apartment
units are rented at a rental price
of $500 per month
June 21, 2014 Ed Dolan’s Econ Blog
Elasticity of Supply and Demand
 Compared with the market for
gasoline, demand is more elastic,
because owning a house or
condominium is a good substitute
for renting an apartment
 The supply is less elastic. An
increase in rents will make a few
more apartments available, but
not very many, at least in the
short run
June 21, 2014 Ed Dolan’s Econ Blog
Effect of a $250 tax on the Supply Curve
 Now suppose the city imposes a
$250 per month on apartment
rentals
 Owners will be willing to supply
the same quantity as before only if
they can raise the rent including
tax by $250
 That means the tax-inclusive
supply curve shifts upward by
$250, from S1 to S2
 The old supply curve S1 shows
what is left for owners after the tax
is paid
June 21, 2014 Ed Dolan’s Econ Blog
Effects on owners and renters
 The tax will affect the choices
made by renters as well as
owners
 As owners attempt to pass the
tax along, renters will move up
and to the left along the demand
curve, reducing the quantity
demanded
 As occupancy of rental
apartments decreases, owners
will move down and to the left
along S1
June 21, 2014 Ed Dolan’s Econ Blog
Equilibrium after tax
 Renters will continue to move
along their demand curve until
they reach point E2, where the
quantity demanded at the price
including tax equals the quantity
supplied
 In the new equilibrium, the rent,
including tax, will be $550 and the
number of apartments occupied
will decrease to 1,600 units
 The rental price per month
received by owners, after the tax
is paid, will fall to $300
June 21, 2014 Ed Dolan’s Econ Blog
Incidence of the Rental Tax
 In the new equilibrium, total tax
collected by the government will
be $400,000 per month, equal to
the area ABFE
 Renters will bear 20% of the
burden, or $80,000 per month,
equal to the area ABDC, because
the price they pay including tax
has gone up by $50
 Owners will bear 80% of the
burden, or $320,000 per month,
equal to the area CDFE, because
the price they receive after the
tax is paid goes down by $200
June 21, 2014 Ed Dolan’s Econ Blog
Conclusions
 The incidence of a tax depends on the
relative elasticity of supply and demand
 If supply is more elastic than demand,
more of the economic burden of the tax
will be born by customers than by
suppliers
 If demand is more elastic than supply,
more of the burden will be born by
suppliers than by customers
 If demand and supply are equally elastic,
the economic burden of the tax will be
divided equally
June 21, 2014 Ed Dolan’s Econ Blog
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Who Really Pays Taxes? The Question of Tax Incidence

  • 1. Economics for your Classroom Ed Dolan’s Econ Blog Who Really Pays Taxes? The Question of Tax Incidence June 21, 2014 Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.
  • 2. Who Really Pays Taxes?  Governments have been collecting taxes since the dawn of history, but there is still confusion over who really pays them  The question of tax assessment tells us who bears the legal responsibility for paying a given tax.  The question of tax incidence tells us who bears the economic burden of a tax  This slideshow will explain why the answers to these two questions are not the same June 21, 2014 Ed Dolan’s Econ Blog Sign on an abandoned gasoline pump: 29.9 cents per gallon, all taxes included
  • 3. Example 1: A gasoline tax  Suppose that in the state of Virginia, there is initially no gasoline tax  The gasoline market is in equilibrium at point E1, where the price is $2 per gallon and the quantity sold is 10 million gallons per day June 21, 2014 Ed Dolan’s Econ Blog
  • 4. Elasticity of Supply and Demand  The elasticity of supply and demand will play an important part in our story  Elasticity means the percentage change in quantity associated with a 1 percent change in price  Notice that in the neighborhood of the equilibrium point, supply is more elastic than demand, that is, a 1 percent change in price would cause a larger percentage change in the quantity supplied than in the quantity demanded June 21, 2014 Ed Dolan’s Econ Blog
  • 5. Effect of a $1 per Gallon Tax on the Supply Curve  Now suppose the state imposes a $1 per gallon tax  Sellers will be willing to supply the same quantity as before only if they can raise the price including tax by $1  That means the tax-inclusive supply curve shifts upward by $1, from S1 to S2  The old supply curve S1 shows what is left for sellers after the tax is paid June 21, 2014 Ed Dolan’s Econ Blog
  • 6. Effects of a $1 per Gallon Tax on Quantity Supplied and Demanded  The tax will affect the choices made by buyers as well as sellers  As sellers attempt to pass the tax along, consumers will move up and to the left along the demand curve, reducing the quantity demanded  As buyers purchase less gasoline, sellers will move down and to the left along S1 June 21, 2014 Ed Dolan’s Econ Blog
  • 7. New Equilibrium After the Tax  Consumers will continue to move along their demand curve until they reach point E2, where the quantity demanded at the price including tax equals the quantity supplied  In the new equilibrium, the price, including tax, will be $2.80 and the quantity will fall to 8 million gallons per day  The price received by sellers, after the tax is paid, will fall to $1.80 June 21, 2014 Ed Dolan’s Econ Blog
  • 8. Incidence of the Gasoline Tax  In the new equilibrium, total tax revenue will be $8 million per day, equal to the area of the entire shaded rectangle ABFE  Consumers will bear 80% of the burden ($6.4 million), equal to the blue shaded area ABDC, because the price they pay including tax has gone up by 80 cents  Sellers will bear 20% of the burden ($1.6 million), equal to the tan area CDFE, because the price they receive after the tax is paid goes down by 20 cents June 21, 2014 Ed Dolan’s Econ Blog
  • 9. Example 2: A tax on apartment rents  For our second example, consider the market for rental apartments in a small city  In equilibrium 2,000 apartment units are rented at a rental price of $500 per month June 21, 2014 Ed Dolan’s Econ Blog
  • 10. Elasticity of Supply and Demand  Compared with the market for gasoline, demand is more elastic, because owning a house or condominium is a good substitute for renting an apartment  The supply is less elastic. An increase in rents will make a few more apartments available, but not very many, at least in the short run June 21, 2014 Ed Dolan’s Econ Blog
  • 11. Effect of a $250 tax on the Supply Curve  Now suppose the city imposes a $250 per month on apartment rentals  Owners will be willing to supply the same quantity as before only if they can raise the rent including tax by $250  That means the tax-inclusive supply curve shifts upward by $250, from S1 to S2  The old supply curve S1 shows what is left for owners after the tax is paid June 21, 2014 Ed Dolan’s Econ Blog
  • 12. Effects on owners and renters  The tax will affect the choices made by renters as well as owners  As owners attempt to pass the tax along, renters will move up and to the left along the demand curve, reducing the quantity demanded  As occupancy of rental apartments decreases, owners will move down and to the left along S1 June 21, 2014 Ed Dolan’s Econ Blog
  • 13. Equilibrium after tax  Renters will continue to move along their demand curve until they reach point E2, where the quantity demanded at the price including tax equals the quantity supplied  In the new equilibrium, the rent, including tax, will be $550 and the number of apartments occupied will decrease to 1,600 units  The rental price per month received by owners, after the tax is paid, will fall to $300 June 21, 2014 Ed Dolan’s Econ Blog
  • 14. Incidence of the Rental Tax  In the new equilibrium, total tax collected by the government will be $400,000 per month, equal to the area ABFE  Renters will bear 20% of the burden, or $80,000 per month, equal to the area ABDC, because the price they pay including tax has gone up by $50  Owners will bear 80% of the burden, or $320,000 per month, equal to the area CDFE, because the price they receive after the tax is paid goes down by $200 June 21, 2014 Ed Dolan’s Econ Blog
  • 15. Conclusions  The incidence of a tax depends on the relative elasticity of supply and demand  If supply is more elastic than demand, more of the economic burden of the tax will be born by customers than by suppliers  If demand is more elastic than supply, more of the burden will be born by suppliers than by customers  If demand and supply are equally elastic, the economic burden of the tax will be divided equally June 21, 2014 Ed Dolan’s Econ Blog
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