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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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