The effects of taxes on supply and demand What determines who really bears the burden of a tax The costs and benefits of taxes and why taxes impose a cost that is larger than the tax revenue they raise The difference between progressive and regressivetaxes and the trade-off between tax equity and tax efficiency The structure of the U.S. tax system To First Active Learning To Video What you will learn in this chapter 1 WHISKEY’S FOR DRINKING… AND TAXING. Taxes matter: Washington’s 1791 tax on whiskey distillers led to the Whiskey Rebellion of 1794, the decline of small distillers, and local economies—and the rise of the Republican Party. Back to Table of contents image credit: The Granger Collection, New York 2 THE EFFECT OF AN EXCISE TAX ON QUANTITIES AND PRICES Taxes drive a wedge between the price buyers pay and the price sellers receive. To analyze the effects, we’ll graph two scenarios: when the tax is levied on sellers when the tax is levied on buyers The incidence of a tax is a measure of who really pays it. Back to Table of contents 3 AN EXCISE TAX IMPOSED ON HOTEL OWNERS S1 S2 A B 0 5,000 10,000 15,000 $140 120 100 80 60 40 20 Quantity of hotel rooms Price D E Excise tax = $40 per room Supply curve shifts upward by the amount of the tax. The equilibrium price of hotel rooms rises to $100 a night. And the quantity falls to 5,000 Hotel guests bear some of the burden as price RISES from $80 to $100. Hotel owners also bear some of the burden as their price (net of the tax paid) FALLS from $80 to $60. The $40 excise tax is shared between buyers and sellers. Back to Table of contents AN EXCISE TAX IMPOSED ON HOTEL GUESTS A B 0 5,000 10,000 15,000 $140 120 100 80 60 40 20 Quantity of hotel rooms E S D 2 D 1 Excise tax = $40 per room Demand curve shifts downward by the amount of the tax. Price The equilibrium price of hotel rooms falls to $60 a night. And the quantity falls to 5,000. Hotel guests also bear some of the burden as price RISES from $80 to $100 (after taxes are paid). Hotel owners bear some of the burden as their price FALLS from $80 to $60. The incidence of an excise tax doesn’t depend on who officially pays the tax. Back to Table of contents If A is the buyer price and B the seller price, how large is the per-unit tax imposed on the graph? $5 $10 $15 $50 $1,000 A B 0 100 200 300 $35 30 25 20 15 10 5 E S D1 Price Quantity To Next Active Learning LEARN BY DOING: PRACTICE QUESTION Back to Table of contents 6 PRICE ELASTICITIES AND TAX INCIDENCE In a long-distance relationship, who will do more of the driving? Does the “tax” fall more heavily to the more committed partner? Although both buyer and seller share the burden of the tax, it’s not necessarily an equal burden. Back to Table of contents All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified 7 This pleasure boat seems like a good ...

1. The effects of taxes on supply and demand
What determines who really bears the burden of a tax
The costs and benefits of taxes and why taxes impose a cost that
is larger than the tax revenue they raise
The difference between progressive and regressivetaxes and the
trade-off between tax equity and tax efficiency
The structure of the U.S. tax system
To First
Active Learning
To Video
What you will learn in this chapter
1
WHISKEY’S FOR DRINKING… AND TAXING.
Taxes matter: Washington’s 1791 tax on whiskey distillers led
to the Whiskey Rebellion of 1794, the decline of small
distillers, and local economies—and the rise of the Republican
Party.
Back to Table of contents
image credit: The Granger Collection, New York
2

2. THE EFFECT OF AN EXCISE TAX ON QUANTITIES AND
PRICES
Taxes drive a wedge between the price buyers pay and the price
sellers receive.
To analyze the effects, we’ll graph two scenarios:
when the tax is levied on sellers
when the tax is levied on buyers
The incidence of a tax is a measure of who really pays it.
Back to Table of contents
3
AN EXCISE TAX IMPOSED ON HOTEL OWNERS
S1
S2
A
B
0
5,000
10,000
15,000
$140
120

3. 100
80
60
40
20
Quantity of hotel rooms
Price
D
E
Excise tax = $40 per room
Supply curve shifts upward by the amount of the tax.
The equilibrium price of hotel rooms rises to $100 a night.
And the quantity falls to 5,000
Hotel guests bear some of the burden as price RISES from $80
to $100.
Hotel owners also bear some of the burden as their price (net of
the tax paid) FALLS from $80 to $60.
The $40 excise tax is shared between buyers and sellers.
Back to Table of contents

4. AN EXCISE TAX IMPOSED ON HOTEL GUESTS
A
B
0
5,000
10,000
15,000
$140
120
100
80
60
40
20
Quantity of hotel rooms
E
S
D
2
D
1
Excise tax = $40 per room

5. Demand curve shifts downward by the amount
of the tax.
Price
The equilibrium price of hotel rooms falls to $60 a night.
And the quantity falls to 5,000.
Hotel guests also bear some of the burden as price RISES from
$80 to $100 (after taxes are paid).
Hotel owners bear some of the burden as their price FALLS
from $80 to $60.
The incidence of an excise tax doesn’t depend on who officially
pays the tax.
Back to Table of contents
If A is the buyer price and B the seller price, how large is the
per-unit tax imposed on the graph?
$5
$10
$15
$50
$1,000
A

6. B
0
100
200
300
$35
30
25
20
15
10
5
E
S
D1
Price
Quantity
To Next
Active Learning
LEARN BY DOING: PRACTICE QUESTION
Back to Table of contents

7. 6
PRICE ELASTICITIES AND TAX INCIDENCE
In a long-distance relationship, who will do more of the
driving?
Does the “tax” fall more heavily to the more committed partner?
Although both buyer and seller share the burden of the tax, it’s
not necessarily an equal burden.
Back to Table of contents
All image credits courtesy of Morgue File and/or
FreeImages.com unless otherwise specified
7
This pleasure boat seems like a good thing to tax…
Or not: The Omnibus Budget Reconciliation Act of 1990
applied a 10% federal luxury tax to the retail sale of luxury
goods like pleasure boats with a sales price above $100,000.
Expected tax revenue? $9 billion. Reality?
Sales of boats went down 52.7%.
Net 30,000 jobs were lost.
The federal government paid out more than $7 million more in
unemployment benefits to those workers than it collected in
luxury tax revenues.
The federal luxury tax was repealed in 1993.
HOW NOT TO TAX…

8. To Next
Active Learning
Back to Table of contents
All image credits courtesy of Morgue File and/or
FreeImages.com unless otherwise specified
8
WHEN AN EXCISE TAX IS PAID MAINLY BY CONSUMERS
D
S
$2.95
2.00
1.95
Price of gasoline (per gallon)
0
Quantity of gasoline (gallons)
Tax burden falls mainly on consumers.

9. Excise tax = $1 per gallon

10. When the price elasticity of demand is low and the price
elasticity of supply is high, the burden of an excise tax falls
mainly on consumers.
Back to Table of contents
WHEN AN EXCISE TAX IS PAID MAINLY BY PRODUCERS
D
S

11. $6.50
6.00
1.50
Price of parking space
0
Quantity of parking spaces
Tax burden falls mainly on producers.
Excise tax =
$5 per
parking space.

13. When the price elasticity of demand is high and the price
elasticity of supply is low, the burden of an excise tax falls
mainly on producers.
Back to Table of contents
If demand of some good is more elastic than supply and a tax is
imposed on the consumption of the good, who will bear more of
the burden of the tax?

14. Producers, because consumers have a greater ability to change
their behavior in response to the tax.
Both parties will share the burden equally.
Consumers, because they pay the tax out of pocket.
The government, because the tax will cause less of the good to
be produced and consumed.
To Next
Active Learning
LEARN BY DOING: PRACTICE QUESTION
Back to Table of contents
11
Junk food has been criticized for being unhealthy and too cheap,
enticing the poor to adopt unhealthy lifestyles. Suppose that the
state of Oklahansas imposes a tax on junk food. What has to be
true for the tax to actually deter the most people from eating
junk food: Should junk food demand be elastic or should it be
inelastic?
Demand should be perfectly inelastic.
Demand should be elastic.
To Next
Active Learning
LEARN BY DOING: PRACTICE QUESTION

15. Back to Table of contents
12
In 2010, New York contemplated a $1/pack cigarette tax. This
video highlights the costs of the tax. Click here (or on the
picture below). (1:22 minutes)
Copyright 2016 Worth Publishers
Back to Table of contents
LEARN BY DOING: APPLICATION VIDEO
http://www.youtube.com/watch?v=GPDqpXWJXho
13
THE BENEFITS AND COSTS OF TAXATION
More children are born in late December than in early January,
and the extra births appear to be clustered among those who
have the most to gain from a tax deduction.
Unless you’re a cynic, or an economist, I realize you might have
trouble believing that the intricacies of the nation’s tax code
would impinge on something as sacred as the birth of a child.
But it appears that you would be wrong.
— David Leonhardt, The New York Times

16. Back to Table of contents
All image credits courtesy of Morgue File and/or
FreeImages.com unless otherwise specified
14
THE REVENUE FROM AN EXCISE TAX
S
B
6
0
5,000
10,000
15,000
$140
120
100
80
60
40
20
Quantity of hotel rooms
D
E

17. Area = tax revenue
Excise tax = $40 per room.
A
Price of hotel room
The tax revenue collected =
$40 per room × 5,000 rooms = $200,000
Back to Table of contents
If A is the buyer price and B the seller price, how large is the
government revenue from a $10 per-unit tax?
$5
$10
$15
$50
$1,000
A
B

18. 0
100
200
300
$35
30
25
20
15
10
5
E
S
D1
Price
Quantity
To Next
Active Learning
LEARN BY DOING: PRACTICE QUESTION
Back to Table of contents

19. 16
INCREASING THE TAX RATE DOES NOT NECESSARILY
INCREASE REVENUE
Quantity of hotel rooms
Price of hotel room
S
6
0
,000
7,500
10,000
15,000
$140
120
80
90
70
40
20
D
E

20. (a) An excise tax of $20
S
0
5,000
2,500
10,000
15,000
$140
120
110
80
50
40
20
D
E
(b) An excise tax of $60
Price of hotel room
Quantity of hotel rooms
Excise tax = $20 per room.
Excise tax = $60 per room.
Area = tax revenue

21. Area = tax revenue
Tax revenue= $150,000
Tax revenue= $150,000
Back to Table of contents
THE COSTS OF TAXATION: REDUCTION IN CONSUMER
AND PRODUCER SURPLUS
QE
Quantity
S
E
D
Price

22. QT
PL
PC
PP
C
A
B
F
Excise tax = T
Fall in consumer surplus due to tax

24. Fall in producer surplus due to tax
Lost surplus is called deadweight loss.

25. Back to Table of contents
THE EFFECTS OF A TAX
Consumer surplus— consumers get this.
Deadweight loss—no one gets this.
Tax
Price buyer pays = $2.65.
Price seller receives = $1.65.
500 = QT
A Tax generates revenue and creates a deadweight loss.
Price
Quantity
700 = QE
Demand
Supply
Tax revenue—the government gets this.
Tax Revenue
= $500
tax = $1
Producer surplus—producers get this.
Back to Table of contents

26. If A is the buyer price and B the seller price, how large is the
deadweight loss from a $10 per-unit tax?
$5
$10
$15
$500
$1,000
A
B
0
100
200
300
$35
30
25
20
15
10
5
E
S
D1

27. Price
Quantity
To Next
Active Learning
LEARN BY DOING: PRACTICE QUESTION
Back to Table of contents
20
Using the framework below, draw two demand curves, one
elastic, one inelastic. Show how, all else equal, the size of the
deadweight loss is larger with elastic demand.
For each graph, label the:
Consumer and producer price and new quantity traded.
Area of government revenue.
Consumer and producer surplus before and after the tax.
Area of deadweight loss.
To Next
Active Learning
LEARN BY DOING: PRACTICE QUESTION
Back to Table of contents

28. 21
DEADWEIGHT LOSS AND ELASTICITIES
Quantity
D
E
(a) Elastic demand
(b)
Inelastic demand
Quantity
D
S
E
S

29. Deadweight loss is larger when demand is elastic.
QE
QE
QT
QT
PE
PC
PP
PE
PC
PP
Excise tax = T.
Excise tax = T
Deadweight loss is smaller when demand is inelastic.
Price
Price
Back to Table of contents
DEADWEIGHT LOSS AND ELASTICITIES
(c) Elastic Supply
(d)

30. Inelastic Supply
Quantity
Price
D
E
S
Quantity
D
E
S
P
E
P
C
P
P
P

31. E
P
C
P
P
Q
E
Q
E
Q
T
Q
T
Excise tax = T
Excise tax = T
Deadweight loss is smaller when supply is inelastic
Deadweight loss is larger when supply is elastic
Price
Back to Table of contents
DEADWEIGHT LOSS AND ELASTICITIES
If the goal in in tax policy is efficiency (minimizing deadweight
loss), then policymakers should choose the goods with the
lowest price elasticities.

32. A tax on insulin would be efficient—but not necessarily fair.
Back to Table of contents
All image credits courtesy of Morgue File and/or
FreeImages.com unless otherwise specified
Your mayor has asked you to come up with an excise tax that
will be as efficient as possible.
With a partner, choose a good to be taxed and explain why it
will cause a low deadweight loss.
Back to Table of contents
LEARN BY DOING: DISCUSS
25
TAX FAIRNESS AND TAX EFFICIENCY
Two principles of tax fairness:
The benefits principle: Those who benefit from public spending
should bear the burden of the tax that pays for that spending.
The ability-to-pay principle: Those with greater ability to pay a
tax should pay more tax.
There is usually a trade-off between equity and efficiency: The
system can be made more efficient only by making it less fair,
and vice versa.

33. Back to Table of contents
All image credits courtesy of Morgue File and/or
FreeImages.com unless otherwise specified
UNDERSTANDING THE TAX SYSTEM
Some important taxes and terms:
The tax base is the measure, such as income or property value,
that determines how much tax an individual or firm pays.
Taxed on each barrel of whiskey you produce? Then whiskey is
your tax base.
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All image credits courtesy of Morgue File and/or
FreeImages.com unless otherwise specified
UNDERSTANDING THE TAX SYSTEM
Some important taxes and terms:
Lump-sum tax is the same for everyone, regardless of any
actions people take.
Income tax depends on income from wages and investments.
Payroll tax depends on the earnings an employer pays to an
employee.
Sales tax depends on the value of goods sold.
Profits tax depends on a firm’s profits.
Property tax depends on the value of property, such as a home.

34. Wealth tax: a tax that depends on an individual’s wealth.
Back to Table of contents
UNDERSTANDING THE TAX SYSTEM
The tax structure specifies how the tax depends on the tax base.
A progressive tax takes a larger share of the income of high-
income taxpayers than of low-income taxpayers.
A regressive tax takes a smaller share of the income of high-
income taxpayers than of low-income taxpayers.
The marginal tax rate is the percentage of an increase in income
that is taxed away.
Back to Table of contents
MAJOR TAXES IN THE UNITED STATES, 2013
Back to Table of contents
FEDERAL, STATE, AND LOCAL TAXES AS A PERCENT OF
INCOME, BY INCOME CATEGORY, 2013

35. Back to Table of contents
31
YOU THINK YOU PAY HIGH TAXES?
OECD, 2013
Back to Table of contents
32
TOP U.S. MARGINAL INCOME TAX RATES FOR 100
YEARS
Back to Table of contents
33
Amazon versus BarnesandNoble.com
Were Amazon’s lower prices due to tax law?
Whereas firms with “bricks-and-mortar” locations in a state
were required to pay sales tax, Amazon was not.
As of 2014, Amazon pays taxes in 19 states – and is building
warehouses in those states to speed delivery.

36. Back to Table of contents
LEARN BY DOING: BUSINESS CASE
34