Who really pays taxes? This sideshow explains why the person who is legally obligated to pay them is not always the person who bears the economic burden

1. Economics for your Classroom
Ed Dolan’s Econ Blog
Who Really Pays Taxes?
The Question of Tax Incidence
June 21, 2014
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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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