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Taxation, Prices, Efficiency,

and the Distribution of Income

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NSTRUCTIONAL

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BJECTIVES

This chapter is designed to make students aware of the impact of taxes in markets. The emphasis is on

the effect taxes have on prices and how taxes change prices in ways that affect efficiency and income

distribution. This is a very important chapter because it develops the techniques of analysis that will be

used in the following chapters on tax policy. The student should be advised to read this chapter carefully.

The student should understand the concept of a lump-sum tax as a benchmark for comparing taxes.

It is important for the student to realize that a lump- sum tax results in income effects but has no substitu-

tion effects. The student should also thoroughly comprehend how a price- distorting tax causes losses in

efficiency by making buyers and sellers react to different prices. This requires that the student be able to

use supply-and- demand analysis to show the excess burden of the tax and understand how it varies with

key factors.

Another goal is to show how tax-induced changes in prices affect income shares. The student should

see that tax incidence is independent of the legal liability for taxes. It is very important to make it clear

that tax incidence depends on market conditions rather than on whims of sellers to raise prices. Various

techniques for evaluating the impact of taxes on the actual distribution of income are also discussed in

the chapter.

C

HANGES IN

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HIS

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DITION

There were no changes in this core theory chapter.

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UTLINE

Lump-Sum Taxes: A Benchmark Standard for Comparison

Lump-Sum versus Price- Distorting Taxes:

Indifference Curve Analysis

International View: The Lump- Sum Tax Takes Its Lumps in the U.K.

The Impact of Taxes on Market Prices and Efficiency

A Unit Excise Tax:

Impact of Market Equilibrium

Excess Burden of a Unit Tax

Excess Burden, Unit Taxes, and Price Elasticities

The Efficiency-Loss Ratio of a Tax

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Part Three

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Financing Government Expenditures

Incidence of a Unit Tax

Ad Valorem Taxes

Ad Valorem Taxes on Labor

Public Policy Perspective: Using Excise Taxes on Alcohol in the United States to Internalize

Externalities

Further Analysis of Tax Incidence

Tax Incidence as Independent of Legal Liability for Taxes

Tax Incidence and Price Elasticities of Demand and Supply

Shifting under Monopoly

General Equilibrium Analysis of Excess Burden and Incidence of Taxes

Minimizing the Excess Burden of Sales and Excise Taxes

Multimarket Analysis of Incidence

Taxes, Government Expenditures, and the Distribution of Income

Budget and Expenditure Incidence

Differential Tax Incidence

The Lorenz Curve

Measuring Income Inequality: The Gini Coefficient

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OINTS AND

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ECTURE

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UGGESTIONS

1.

It is essential to make sure students understand that much of the analysis in the chapter assumes

perfect competition in markets. Individual sellers and buyers have no influence over the price.

Emphasize that no single seller can raise the price in response to a tax. The way a tax affects price,

and therefore quantity exchanged, in a market depends on conditions of demand and supply in the

market.

2.

I also emphasize that although evaluating the fairness of taxes is subjective, it requires accurate

data on the impact of taxes on prices. Once again, this requires understanding of the way taxes

affect market equilibrium for the taxed good and related goods.

3.

The student must understand how economists use lump-sum taxes as a benchmark for evaluating

price- distorting taxes. A price-distorting tax is one that causes the net price received by sellers to

diverge from the gross price paid by buyers. If you can get this point across to students, they will

be much less likely to be confused later on. Point out that any tax must reduce incomes to release

productive resources for government use. A lump-sum tax accomplishes this without preventing

the prices of taxed goods from simultaneously equaling the marginal social benefit and marginal

social cost of goods. A lump-sum tax results in income effects but no substitution effects. Use the

head tax example appearing in the chapter to illustrate how lump-sum taxes can drastically affect

the distribution of income.

4.

The indifference curve analysis of lump-sum versus price-distorting taxes is tough going for most

students. Nonetheless, it is important to show how the lump-sum tax has only an income effect and

how a person will always be better off paying the same amount of tax from a price-distorting tax

in a lump sum. I suggest copying the graph as a handout for students to make it easier for them to

get it into their notes. Also refer the students back to the Appendix to Chapter 1 where indifference

curves between quantity of a particular good and expenditures on all other goods is first presented.

Make it clear that the graph assumes that the market price of the good increases by the full amount

of the tax per unit.

Chapter Eleven

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Taxation, Prices, Efficiency, and the Distribution of Income

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81

5.

In analyzing a unit tax, give examples in class. The gasoline tax is a unit tax, as is the cigarette tax

and liquor tax. Most students will be familiar with shifting supply curves to show the impact of a

tax

. Note how I label the demand curve ―MSB‖ and the supply curve ―MSC.‖ Of course, this assumes

no externalities

—

an assumption that is made explicit. This technique also is consistent with my

analysis of efficiency in Chapter 2 of the text.

6.

In discussing excess burden, make sure students realize that this measures the loss in net benefits

from the taxed good that would not occur if a lump-sum tax were used. This means that the change

in output must reflect only the substitution effect of the tax. If an equal-yield, lump-sum tax were

levied on persons in this market, there would be an income effect but no substitution effect. The

triangle is an accurate measure of excess burden when market supply and demand curves are used

only if the income effects of tax-induced price changes are negligible.

7.

I use a simple formula to estimate the excess burden. Then I give the students an intuitive analysis

of why the excess burden varies quadratically with the tax. The simple formula for the triangle shows

that the excess burden varies with t and the tax induces change in market quantity. This change in

market quantity depends on the change in price, which is a function of the tax. Finally, I present the

formula, which I derive in the appendix that shows how excess burden varies with price elasticities.

I point out the price elasticity of demand as a negative number. That is why there is a minus sign in

the numerator of Equation 11.3. When problems are assigned, treating E

D

as a negative number

makes it easier for students to solve the equation.

8.

The efficiency-loss ratio of a tax is also called its coefficient of inefficiency. This concept is useful

in evaluating the gains and losses of transferring revenue from one tax to another. It is used in most

empirical work on taxes.

9.

Once you have analyzed the excess burden of a unit tax, it is easy to use the same graph to show

how the tax paid is distributed between buyers and sellers. It is easiest to concentrate on the tax per

unit and then show how this relates to total tax paid.

10.

Make sure students see how ad valorem taxes differ from unit taxes. Equation 11.5 helps students

see how the amount of tax paid per unit depends on the price of a good when an ad valorem tax is

used. The same equation is used to derive expressions for the excess burden of an ad valorem tax in

the text.

11.

Note that it makes a difference whether the tax is levied on the gross or net price. In most of my

examples, the tax is levied on the gross price. The difference between taxes on net and gross prices

is a technical point that can be quite confusing. For example, the payroll tax levied on the wages

received by workers is a tax on the

gross

wage

. The workers receive the wage paid by employers,

and then the tax is deducted from the wage. The retail sales tax is actually a tax on the net price

received by sellers. The buyers pay the market price of the good, then sellers are liable for a certain

percentage of that price. This percentage is usually tacked on to the price paid by the buyer. The total

price paid by the buyer is therefore the net price, P

N

, plus the tax, tP

N

. Therefore, P

G

= P

N

(1 + t) for

a retail sales tax. Note how the formulas show students that the initial price and quantity must be

used to compute the excess burden.

12.

The text shows that the incidence of a tax is independent of its legal liability. Most students have a

harder time conceptualizing a tax as a reduction from the marginal benefit received by consumers

than they do seeing it as an addition in marginal cost incurred by sellers. My example shows how

the tax on buyers affects the maximum price they will pay for any given quantity.

13.

Multimarket analysis of incidence shows how a tax in one market can decrease prices in other mar-

kets. Emphasize how this affects incidence of the tax. Also point out how the prices of specialized

inputs for each of the goods can be affected.

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Part Three

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Financing Government Expenditures

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PPENDIX TO

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If your students are above average, you will want to assign the appendix to this chapter. I believe you

will find the material on compensated demand curves and compensated supply curves in this chapter

very useful. Much of the material in the appendix is rarely found in an undergraduate textbook. The

appendix does more than derive formulas. It shows students how the substitution effect of tax-induced

price changes can be isolated by using compensated demand and supply curves. This is done with graphic

analysis that is then used to show how estimates of excess burden made with noncompensated curves can

result in biases.

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UTLINE OF THE

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Derivation of the Formula for the Excess Burden

Excess Burden of an Ad Valorem Tax When the Taxed Good or Service is Produced under Conditions of

Constant Cost

Individual Losses in Welfare under Conditions of Perfect Competition

Compensated Demand Curves

Compensated Supply Curves

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RUE

/F

ALSE

Q

UESTIONS

1.

A lump-sum tax results in both income and substitution effects. (F)

2.

A consumer currently pays $$500 a year retail sales taxes. She would be better off if she paid the

same amount annually as a lump-sum tax. (T)

3.

Clothing is sold in perfectly competitive markets where no externalities prevail. An excise tax on

clothing will result in a market price for clothing that equals the marginal social benefit and mar-

ginal social cost of service. (F)

4.

Assuming that the income effects are negligible and that beer is sold in a competitive market, a

10-cent per can tax on beer that causes a 10,000 can per month decline in sales will result in an

excess burden of $$1,000 per month. (F)

5.

A tax on land results in an income effect on landlords but no substitution effect. Then it follows

that the excess burden of a tax on land will be zero. (T)

6.

The excess burden of a tax on interest income is $$5 billion per year. Total interest income per year

is $$50 billion. The tax currently collects $$15 billion in revenue per year. The efficiency-loss ratio

of the tax is therefore 0.33. (T)

7.

A payroll tax results in a difference between the gross wages paid by employers and the net wages

received by workers. (T)

8.

If the market supply of labor services is perfectly inelastic, a tax on labor income will reduce the

net wages received by workers by the full amount of the tax per labor hour. (T)

9.

If a $$10 per unit tax is levied on the output of a monopolist, more of that tax will be shifted to con-

sumers than would be the case if the same good were produced by a competitive industry. (F)