This document discusses tax incidence and how taxes create inefficiencies in markets. It contains the following key points: 1. Tax incidence refers to how the burden of a tax is divided between buyers and sellers. A tax places a wedge between the price buyers pay and sellers receive. 2. When demand is perfectly inelastic, buyers bear the entire burden of the tax. When supply is perfectly inelastic, sellers bear the entire burden. 3. Taxes result in deadweight losses by creating a wedge between the price buyers are willing to pay and the price sellers are willing to accept. This leads to an inefficient outcome where quantity traded is below the efficient level.

1. “If you put the federal government in
charge of the Sahara Desert, in 5 years
there'd be a shortage of sand.”
Milton Friedman
Nobel Laureate, Economics
(1912 – 2006)

2. TAXES ON BUYERS AND SELLERS
Tax Incidence
Tax incidence is the division of the burden of a tax
between the buyer and the seller.
When a good is taxed, it has two prices:
• A price that includes the tax
• A price that excludes the tax
Buyers respond to the price that includes the tax.
Sellers respond to the price that excludes the tax.

3. TAXES ON BUYERS AND SELLERS
The tax is like a wedge between the two prices.
Suppose that the government puts a $10 tax on MP3
players.
• How does the price paid by the buyer change?
• How does the price received by the seller change?
• How is the burden of a tax shared between the
buyer and the seller?

4. 1. With no tax, the price
is $100 and 5,000
players are bought.
2. A $10 tax on buyers
shifts the demand curve
to D – tax.
What happens when the
government taxes buyers
of the MP3 players?
TAXES ON BUYERS AND SELLERS

5. 3. The buyer’s price rises
to $105—an increase
of $5 a player.
4. The seller’s price falls
to $95—a decrease of
$5 a player.
5. The quantity decreases
to 2,000 players a week.
6. The government’s tax
revenue is $20,000.
TAXES ON BUYERS AND SELLERS

6. 1. With no tax, the price is
$100 and 5,000 players
a week are bought.
2. A $10 tax on sellers of
MP3 players shifts the
supply curve to S + tax.
Shows what happens
when the government
taxes sellers of the MP3
players.
TAXES ON BUYERS AND SELLERS

7. 3. The buyer’s price rises
to $105—an increase
of $5 a player.
4. The seller’s price falls
to $95—a decrease
of $5 a player.
5. The quantity decreases
to 2,000 players a
week.
6. The government’s tax
revenue is $20,000.
TAXES ON BUYERS AND SELLERS

8. A tax places a wedge between the buyers’ price
(marginal benefit) and the sellers’ price (marginal cost).
The equilibrium quantity is less than the efficient
quantity and a deadweight loss arises.
Taxes and Efficiency
TAXES ON BUYERS AND SELLERS

9. The market is efficient with
marginal benefit equal to
marginal cost.
Shows the inefficiency of
taxes.
Total surplus—the sum of
2. Consumer surplus and
3. Producer surplus—is
maximized.
TAXES ON BUYERS AND SELLERS

10. A $10 tax shifts the supply
curve to S + tax.
3. Consumer surplus and
4. Producer surplus shrink.
Shows how taxes create
inefficiency.
5. The government collects
its tax revenue.
6. A deadweight loss arises.
1. Marginal benefit exceeds
2. Marginal cost.
TAXES ON BUYERS AND SELLERS

11. The loss of consumer
surplus and producer
surplus is the burden of
the tax.
The burden of the tax
equals the tax revenue
plus the deadweight
loss.
TAXES ON BUYERS AND SELLERS

12. Excess burden is the
deadweight loss from a
tax.
The excess burden is
(3,000  $10  2), which
equals $15,000.
Excess burden is the
amount by which the
burden of a tax exceeds
the tax revenue received
by the government.
TAXES ON BUYERS AND SELLERS

13. Incidence, Inefficiency, and Elasticity
The incidence of a tax and its excess burden depend on
the elasticites of demand and supply:
• For a given elasticity of supply, the buyer pays a
larger share of the tax, the more inelastic is the
demand for the good.
• For a given elasticity of demand, the seller pays a
larger share of the tax, the more inelastic is the
supply of the good.
• Excess burden is smaller, the more inelastic is
demand or supply.
TAXES ON BUYERS AND SELLERS

14. TAXES ON BUYERS AND SELLERS
Tax Incidence, Inefficiency, and Elasticity of
Demand
Perfectly Inelastic Demand: Buyer Pays and Efficient
Perfectly Elastic Demand: Seller Pays and Inefficient

15. Shows tax incidence in a
market with perfectly inelastic
demand—the market for
insulin.
A tax of 20¢ a dose raises the
price by 20¢, and the buyer
pays all the tax.
Marginal benefit equals
marginal cost, so the outcome
is efficient.
TAXES ON BUYERS AND SELLERS

16. Shows tax incidence in a
market with perfectly elastic
demand—the market for pink
pens.
A tax of 10¢ a pink pen
lowers the price received by
the seller by 10¢, and the
seller pays all the tax.
A deadweight loss arises, so
the outcome is inefficient.
TAXES ON BUYERS AND SELLERS

17. TAXES ON BUYERS AND SELLERS
Tax Incidence, Inefficiency, and Elasticity of
Supply
Perfectly Inelastic Supply: Seller Pays and Efficient
Perfectly Elastic Supply: Buyer Pays and Inefficient

18. Shows tax incidence in a
market with perfectly inelastic
supply—the market for spring
water.
A tax of 5¢ a bottle does not
change the price paid by the
buyer but lowers the price
received by the seller by 5¢.
Marginal benefit equals
marginal cost, so the outcome
is efficient.
The seller pays the entire tax.
TAXES ON BUYERS AND SELLERS

19. Figure 7.4(b) shows tax
incidence in a market with
perfectly elastic supply—the
market for sand.
A tax of 1¢ a pound
increases the price by 1¢ a
pound, and the buyer pays
all the tax.
A deadweight loss arises, so
the outcome is inefficient.
TAXES ON BUYERS AND SELLERS

20. Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand
P
Q
D
S
Tax
Buyers’ share
of tax burden
Sellers’ share
of tax burden
Price if no tax
PB
PS
In this case,
buyers bear
most of the
burden of
the tax.
S-tax

21. Elasticity and Tax Incidence
CASE 2: Demand is more elastic than supply
P
Q
D
S
Tax
Buyers’ share
of tax burden
Sellers’ share
of tax burden
Price if no tax
PB
PS
In this case,
sellers bear
most of the
burden of
the tax.
S-tax