Taxes
Most cities, states, and counties have sales and commodity taxes.
Sales taxes on tax on goods and services with some exemptions. Typically expressed as a % (ie, 5%).
Commodity Taxes
Commodity taxes are taxes on a particular good (ie. gas). For simplicity, assume that this tax is a dollar amount rather than a percentage (ie. $0.05 rather than 2%)
In reality, taxes form a necessary function. Tax revenue is used to fund services such as education, health and welfare, and transportation. For the moment, we are only going to examine the negative impact of commodity taxation. Later, we’ll come back to the positive aspects. Please don’t be a future congressman that falls asleep after this lecture and only remembers “Taxes bad”.
Questions:
What impact do commodity taxes have on total surplus?
Who pays the tax? (incidence)
Legal incidence: describes who is legally responsible for sending the amount of the tax to the government.
Ex) seller is legally responsible for sending sales tax to government
Economic incidence: describes who is actually paying the tax. Economists care about economic incidence, not legal incidence.
Main result: Economic incidence depends on the relative elasticity of supply and demand.
Just because the tax is legally imposed on consumers, doesn’t mean that consumers will pay the tax. Consumers will decrease their buying when the price increases. If consumers are very responsive to the price change, sellers may be willing to accept a lower take-home price rather than have a big decrease in sales. In other words, if consumers are very price responsive and a tax is imposed, the price of the good might not go up by the full amount of the tax because sellers are lowering their take-home price.
Note: In the beginning, we'll illustrate the concept of incidence graphically. Not technically correct, but illustrates intuition.
steep line=inelastic
flat line=elastic.
In reality, we know that elasticity changes along a line. We'll incorporate this later.
A tax creates a difference between the price the consumer pays (Pc) and the price the seller keeps (Ps.). In all the other cases we’ve examined, these two are equal.
Pc-tax= Ps
We know that an increase in price (because of a tax) is a movement along the demand curve. We can construct the effects of a tax by thinking of a shift in the supply curve. This isn’t actually what happens but it illustrates the results of a tax.
Ex) $0.50 tax legally imposed on seller. Assume D elastic and S inelastic.
Imposition of tax means that the cost of producing the good has increased. For each good produced, have to pay tax. Supply curve shifts up by the amount of the tax.
At any Qs, new point on supply curve is 50 cents higher
For any quantity, the difference between the two supply curves = ___________________
Intersection of new S and D tells us the quantity that will be sold in the market (Qt). Because of the tax, there will be a difference between the price consumers actually pay and the price that producers actually receive.
Pc= price paid by consumer
What price does seller receive? (after remitting tax to government?) Ps
Total tax revenue received by government=Qt*t
Amount sold times tax rate = A + B
Tax paid by buyer=A
Tax paid by seller=B
Seller pays larger portion of tax.
Why? Supply more inelastic than Demand, implying that demand is fairly elastic. Thus, people would respond a lot if there was a big price increase. Sellers know this and absorb the largest portion of the tax. As a result, consumers pay only a little of the tax.
Rule: whichever is more inelastic pays more of the tax (think Gumby vs robot man)
So, who pays the tax? Either stockholders (firm owners) or people who supply inputs to firms.
Deadweight loss (DWL) = C
$ loss to society because market produces less than optimal
Knowing the relative elasticities of S, D, and inputs is important when imposing a tax
Ex) luxury tax in 1990
Goal was to raise money from wealthy by imposing tax on luxury goods such as boats
B/c luxury good, D fairly elastic
Suppliers bore majority of tax. Led to layoffs and decreased wages.
Suppose same S and D, but tax legally imposed on buyer. The results would be exactly the same (ie, get same economic incidence). LEGAL INCIDENCE DOES NOT MATTER!
Draw case where D is very inelastic and S is elastic.
Consumer bears most of the burden of the tax
Lets examine the effects on total surplus
Extreme cases:
If S or D are perfectly inelastic, that group bears all the burden of the tax
If perfectly elastic, pay no tax
Ex) In the shoe market, Qd=100-2P and Qs=10+P. Government imposes a $5 tax on consumers. Calculate:
The new quantity of shoes produce in the market
The tax paid by sellers and consumers
DWL
Check that supply is more inelastic than D.
At home practice:
Qd=200-2P, Qs=20+3P. $5 tax on producers.
How much does Q fall? Calculate DWL. Govt tax revenue?
In a few sentences, summarize the main points of this section.
MicroPrinciples Thacher 8/25/08
