Principles of Economics

Economic Analysis of Taxation

Jiaming Mao
Xiamen University
 Copyright © 2014–2018, by Jiaming Mao
This version: Fall 2018
Contact: jmao@xmu.edu.cn
Course homepage: jiamingmao.github.io/principles-of-economics

All materials are licensed under the Creative Commons

Attribution-NonCommercial 4.0 International License.
Taxes

The government levies taxes on many goods and services to raise

revenue to pay for its spending.

The government can make either buyers or sellers pay the tax.

The tax can be a percentage of transaction value (ad valorem tax),

or a specific amount per unit of goods sold (per unit tax).
I In this lecture, we analyze per unit tax, but the general lessons apply to
both forms of taxation.
Unit Tax on Sellers

$0.5 sales tax on ice-cream cones

Unit Tax on Buyers

$0.5 sales tax on ice-cream cones

How Taxes Affect Market Outcomes

Taxes levied on sellers and taxes levied on buyers are equivalent.

I In this example, buyers pay 30 cents more and sellers receive 20 cents
less for each ice-cream cone sold, whether the tax is levied on sellers or
on buyers.

Buyers and sellers share the tax burden1 .

I When the tax is levied on sellers, buyers end up paying part of the tax
in the form of higher price.
I When the tax is levied on buyers, sellers end up paying part of the tax
as a result of reduced demand.

When the government levies a tax on a good, the equilibrium quantity

of the good falls2 : a tax on a market shrinks the size of the market.

1
When neither supply nor demand is perfectly elastic or perfectly inelastic.
2
When neither supply nor demand is perfectly inelastic.
Elasticity and Initial Tax Incidence
Elasticity and Initial Tax Incidence
Elasticity and Initial Tax Incidence
Elasticity and Initial Tax Incidence
Elasticity and Initial Tax Incidence
Elasticity and Initial Tax Incidence
Elasticity and Initial Tax Incidence

Tax incidence: how the burden of a tax is shared among individuals

in an economy.
I Initial tax incidence: how the burden of a tax is initially shared
among participants in the market on which the tax is imposed.

The initial incidence of a tax depends on the price elasticities of supply

and demand: the tax burden falls more heavily on the side of the
market that is less elastic.
I The tax burden falls entirely on the sellers when supply is perfectly
inelastic or demand is perfectly elastic.
I The tax burden falls entirely on the buyers when supply is perfectly
elastic or demand is perfectly inelastic.
Welfare Effects of Taxation
Welfare Effects of Taxation
Welfare Effects of Taxation

Deadweight loss: the fall in total surplus that results from a market
distortion.
Welfare Effects of Taxation

Taxes distort incentives by giving buyers an incentive to consume less

and sellers an incentive to produce less.

Because of distorted incentives, some mutually beneficial trades won’t

happen after a tax is imposed. This results in deadweight loss.
Elasticity and Tax Distortion
Elasticity and Tax Distortion
Elasticity and Tax Distortion

The amount of deadweight loss depends on the price elasticities of

supply and demand: the greater the elasticities of supply and demand,
the greater the deadweight loss of a tax.
I No deadweight loss when supply or demand is perfectly inelastic.

The Ramsey principle of optimal taxation: government should

impose lower tax rates on goods whose supply or demand is more
elastic.
The Ramsey Principle

Labor supply is fairly inelastic, while the supply of capital is highly

elastic. By the Ramsey principle, which one should be taxed at a
higher rate: labor or capital?
I How about groceries and fancy restaurants?

The labor supply of women is traditionally more elastic than the labor
supply of men. By the Ramsey principle, should tax rates on labor
income be lower for women than for men?
I Gender-based taxation
Lump Sum Tax

Not all taxes are distortive: a lump sum tax is a fixed tax that is the
same amount for every person.
I E.g., a tax of $100 per person.

A lump sum tax is the most efficient tax possible: since the tax does
not distort incentives, it does not cause deadweight losses.

However, the lump sum tax is regressive: the poor pays a higher
percentage of their income under a lump sum tax.
I This is why lump sum taxes are rarely observed in reality.
How Taxes Affect Market Outcomes: General Equilibrium
Effects

The discussion so far has focused on analyzing the short run, partial
equilibrium effects of a tax.
I i.e., the analysis shows the short run effects of a tax on the market on
which it is imposed, ignoring the effects the tax may have on other
markets.

In reality, a tax imposed on one market can have effects on other

markets.
I i.e., a tax has general equilibrium effects.
How Taxes Affect Market Outcomes: General Equilibrium
Effects

Imposing a tax on good X may not only affect X’s equilibrium quantity
demanded and supplied, but also:

the demand for related goods (complements/substitutes)

I A tax on gasoline increases the demand for alternative fuels and
decreases the demand for cars.
F In this case, car manufacturers share part of the burden of the tax,
while alternative fuel producers benefit from the tax.

I Changes in the demand for related goods will cause changes in their
prices, which will in turn affect the demand for X. This is known as the
feedback effect.
Example (Feedback Effect)
Imposing a tax on beer sellers shifts beer supply from SB → SB0 . The
increase in beer price shifts wine demand from Dw → Dw0 . The increase in
wine price in turn shifts beer demand demand from DB → DB0 , and so on.
The process continues until reaching equilibrium price and quantity in both
markets.
How Taxes Affect Market Outcomes: General Equilibrium
Effects

Imposing a tax on good X may not only affect X’s equilibrium quantity
demanded and supplied, but also:

the supply of other goods

I After a tax is imposed on the fast food industry, some fast food
restaurants may change into healthy food restaurants and some
investors who would have invested in fast food restaurants will invest in
other businesses.
I A tax on labor earnings in the financial industry increases labor supply
in other industries.
I In these cases in which some sellers shift to sell other goods, consumers
of those other goods benefit from the tax.
How Taxes Affect Market Outcomes: General Equilibrium
Effects

Imposing a tax on good X may not only affect X’s equilibrium quantity
demanded and supplied, but also:

the demand for inputs used to produce X

I A tax on trucks decreases the demand for truck tires and truck drivers.
F In this case, tire manufacturers and truck drivers share part of the
burden of the tax.

the supply of goods for which X serves as an input

I A tax on rubber decreases the supply of tires.
F In this case, tire consumers share part of the burden of the tax.
How Taxes Affect Market Outcomes: General Equilibrium
Effects

Who pays for a tax on housing?

Impact on:
Housing market
Rental market
Construction industry
Other capital markets
Individual consumption and savings
etc.
How Taxes Affect Market Outcomes: Short Run vs. Long
Run

Demand and supply are more elastic in the long run.

I A tax on wine may be borne mainly by the wineries in the short run as
their vines and equipments cannot be wasted. In the long run, the
vines may be dug up and the land shifted to other crops, causing the
tax burden to be shifted to consumers.
I A tax on local factories is borne by the factories and their workers in
the short run. In the long run, factories can move to other places.
I A tax on cosmetic surgery may be borne mainly by the cosmetic
surgeons in the short run. In the long run, fewer people will become
cosmetic surgeons, causing the tax burden to be shifted to consumers
in the long run.
How Taxes Affect Market Outcomes: Short Run vs. Long
Run

By changing the incentives in different markets, taxes can affect

people’s consumption, production, savings, and investment decisions,
leading to long run consequences.
I Taxes on labor are borne by workers and to a lesser extent by firms in
the short run. In the long run, firms may shift labor-intensive
production offshore and workers may be discouraged from investing in
human capital, resulting in lower productivity and long run growth.
I Taxes on capital may discourage savings and investment, leading to
lower future capital stock. They could also discourage R&D. Both lead
to lower productivity and long run growth.
How Taxes Affect Market Outcomes

The final tax incidence measures the changes in individual welfare

after all the economic adjustments to the tax have occurred across all
affected markets.

Because initial and final tax incidence differ, the Ramsey principle of
optimal taxation may not be optimal.
Unit Subsidy on Buyers
Unit Subsidy on Sellers
Welfare Effects of a Subsidy
Subsidies

A subsidy is a negative tax.

Subsidies given to sellers and subsidies given to buyers are equivalent.

The side of the market that is less elastic benefits more from a subsidy
in its initial incidence.

The greater the elasticities of supply and demand, the greater the
deadweight loss of a subsidy.
EITC

The Earned Income Tax Credit (EITC) is a tax benefit in the U.S.
for low-to-middle income working individuals and households. The
amount of benefit rises with income up to a maximum amount.

The goal of the EITC is to help the poor while encouraging them to
work, potentially avoiding the problems of welfare programs, which
may disincentivize working, and higher minimum wages, which may
cause unemployment.
EITC

Source: Tax Policy Center

EITC

Source: Rothstein (2010)

Who Benefits from College Financial Aid?

The U.S. government uses financial aid programs to help students

from poorer families afford college.
I There are three main types of financial aid: grants, subsidized loans,
and unsubsidized loans.

As the government increases financial aid for students, however,

college tuition is rising even faster. As a result, college is becoming
more unaffordable.
I Average undergraduate tuition nearly doubled between 2001 and 2012.
Who Benefits from College Financial Aid?

Source: WSJ
Who Benefits from College Financial Aid?

Source: WSJ
Who Benefits from College Financial Aid?

Bennett Hypothesis: increase in financial aid leads to tuition

inflation.
“If anything, increases in financial aid in recent years have enabled
colleges and universities blithely to raise their tuitions, confident
that Federal loan subsidies would help cushion the increase.” –
William J. Bennett, New York Times, 1987/2/18
Who Benefits from College Financial Aid?

Source: Lucca et al. (2017)

Who Benefits from College Financial Aid?

Stock Market Reactions to Changes in Federal Aid Policy (based on a portfolio of 14

publicly traded for-profit universities). Source: Lucca et al. (2017)
Acknowledgement

Part of this lecture is adapted from the following sources:

Mankiw, N. G. (2017). Principles of Economics (8th ed.). Boston,

MA: Cengage Learning.
Reference

Bennett, W. J. 1987. “Our Greedy Colleges,” The New York Times,

Feb. 18, 1987.
Lucca, D. O., T. Nadauld, and K. Shen. 2017. “Credit Supply and the
Rise in College Tuition: Evidence from the Expansion in Federal
Student Aid Programs,” Federal Reserve Bank of New York Staff
Reports No. 733.
Mitchell, J. 2015. “Federal Aid’s Role in Driving Up Tuitions Gains
Credence,” The Wall Street Journal, Aug. 2, 2015.
Rothstein, J. 2010. “Is the EITC as Good as an NIT? Conditional Cash
Transfers and Tax Incidence,” American Economic Journal: Economic
Policy, 2(1).
Tax Policy Center. 2018. “Briefing Book: A citizen’s guide to the
fascinating (though often complex) elements of the federal Tax
System,” Washington, DC: Urban Institute and Brookings Institution.