1REVENUE SYSTEMTAX INCIDENCEPlanPlann Revenue Systemn Tax incidence:q Statutoryq Economicn Determinants of the economic incidenceq Partial equilibrium frameworkn Demand and supply elasticityn Market structuren Stock versus Flow taxationRevenue SystemRevenue Systemn Deficit Financeq To finance government expendituresq To (partially) control Macroeconomic stabilityn Taxesq To finance government expendituresq To correct for externalitiesq To redistribute incomeEffect of TaxesEffect of Taxesn Taxes alter prices and (real) incomen Therefore, they induce changes in economic behaviorn This leads to changes in allocation of goods in the economyØ Thus, we need to understandØ Efficiency implications of imposing a tax Ø Equity implications thereof2The way aheadThe way aheadn Tax incidence (Chapter 12): q Who bears the burden of taxes?q How will a tax affect economic behavior and the resulting allocation of goods?n Optimal Taxation (Chapters 13, 14)q Criteria for tax designq What is the best available tax to achieve the desired objective?Tax IncidenceTax Incidencen Statutory incidence of a taxq Who is legally responsible for the tax?n Economic incidence of a taxq The change in the distribution of private real income induced by the taxNote: Only people bear taxes.Economic and statutory incidence may differ, so that the tax may be ”shifted”.Partial Equilibrium FrameworkPartial Equilibrium FrameworkPerfect CompetitionPerfect Competitionn What is the relationship between statutory incidence and economic incidence?q Unit tax on commoditiesn Paid by producern Paid by consumerq Ad valorem tax on commoditiesn Paid by producern Paid by consumerUnit tax on CommoditiesUnit tax on Commoditiesn Suppose producers (sellers) have to pay $u per gallon of the gasoline sold.q Draw the market equilibrium before and after imposition of the taxq How will the consumer and producer price change?q Who will bear higher economic burden?n Now suppose the consumers (buyers) have to pay the same tax.q How will your analysis differ from the previous case?3Unit tax on Commodities, conclusionsUnit tax on Commodities, conclusionsn The economic incidence of a unit tax is independent of statutory incidencen The economic incidence of a unit tax depends on the elasticities of supply and demandq More tax is shifted on the producers if n The supply if more inelastic or ifn The demand is more elasticAd Ad ValoremValorem TaxTaxn Ad valorem tax is a proportional tax.n Consider a market for good X.n Find the equilibrium.n Assume that a 20% tax is imposed on the consumer.n Find the after-tax equilibrium:q Quantity sold and boughtq Consumer and producer pricesn Calculate the tax incidenceq The change in consumer priceq The change in producer priceXPXPSD+=−= 2,10Ad Ad ValoremValorem TaxTaxConsider a market for good X.n Find the equilibrium.n Assume that a 20% tax is imposed on the producer.n Find the after-tax equilibrium:q Quantity sold and boughtq Consumer and producer pricesn Calculate the tax incidenceq The change in consumer priceq The change in producer priceXPXPSD+=−= 2,10Ad Ad ValoremValorem tax, continuedtax, continuedn Why was the tax burden distributed equally in the previous example?q Elasticity of both supply and demand were equal(compute them).n What if they are not equal?4Ad Ad ValoremValorem Tax, another example Tax, another example n Consider a different market for Xn Calculate the incidence of a 20% tax (on producer).n Who bears higher burden: the consumer of the producer?n Why? XPXPSD32;10+=−=Tax incidence under imperfect Tax incidence under imperfect competition: Monopoly casecompetition: Monopoly casen Assume a monopolist faces a downward sloping demand curve.n And a unit tax is imposed on the consumers.n How will the outcome (quantity produced, consumer and producer price change)?n Who will bear the burden?Tax on ProfitsTax on Profitsn We saw that commodity taxation (economic) incidence does not depend on the statutory incidence.q Rather, it depends on the elasticity of supply and demand.n If the tax is imposed on the firm’s profits, the firm (producer) bears all the burden.n WHY?Tax Incidence and CapitalizationTax Incidence and Capitalizationn Assume you bought a house and the property taxes were suddenly increased.n Will the price of your house change and if so, how?n Taxes are paid over time.n Under capitalization, the price of an asset incorporates the stream of tax payments.5Tax CapitalizationTax Capitalizationn The price of the asset should fall by the present value of the tax payments:n Thus, the owner of the asset bears all the burden.( ) ( )...1...112++++++++TrururuuCapitalization of taxes and local Capitalization of taxes and local amenities: Local Economyamenities: Local Economyn Resident (homogeneous) workers and resident (homogeneous) firmsn Workers derive utility from a composite good, land and public goods and local amenities;n Firms use workers, land, capital and (public) infrastructure to produce a composite good;n Land and labor markets clear in each locality;n Both workers and firms are mobile, they can choose any region to locate inn Public goods and taxes are exogenouswages, rent, ()0,;,VPWVrrr=⋅G()0 ;,ππ=⋅,GrrrPW0rPrWLocal EquilibriumLocal Equilibriumwages, rent, ()0,;,VPWVrrr=⋅G()0 ;,ππ=⋅,GrrrPW0rPrWAn Improvement in InfrastructureAn Improvement in Infrastructure()0 ';,ππ=⋅,GrrrPWrWrW'rPrP'6Conclusionsn Both taxes and local amenities can capitalize in house prices.n Taxes and local amenenities can also be reflected in local wagesn Can you explain a positive relationship between wages and crime rates across