Exam Prep: Supply & Demand, Taxes, & Tax Incidence

Administrative Announcements

  • Upcoming Assignments: New assignments will open tomorrow, heavily utilizing the supply and demand model, which was also central to Exam 1.
  • Assistance Resources:
    • TA Office Hours: Monday, Wednesday, Friday, 5:00 \, \text{PM} to 7:00 \, \text{PM} at the Tiger Shooter Center. No appointment necessary.
    • Instructor Office Hours: Monday, Wednesday, Friday, 1:30 \, \text{PM} to 2:30 \, \text{PM}}. Walk-ins are welcome. If these times do not work, email the instructor to schedule an alternative.
    • Importance: Students are strongly encouraged to seek assistance, especially if they did not perform as well as desired on Exam 1. The instructor offers to review Exam 1 with students to solidify foundational understanding before Exam 2.
  • Grade Reconciliation: Grades for Exam 1 and iClicker participation are being imported and reconciled on Canvas. Students are asked for patience; an announcement will be sent once all updates are complete.
  • iClicker Policy: Continue to attend and answer iClicker questions. Random attendance checks are performed. Not being present in the auditorium when a question is asked or during an attendance check is an academic integrity violation.
  • Exam 2 Information: Exam 2 is scheduled for the week of October 15/16. Early assistance is crucial as topics (like taxes and subsidies) build on the supply and demand model and will not disappear.
  • Exam Review Sessions: Due to overwhelming turnout for the Monday night review (some students were turned away), a second review session will be opened through the tutoring center on Mondays. More details on timing and logistics will be provided soon.

Chapter 6: Taxes and Subsidies

  • Overall Theme: This entire exam unit builds upon the supply and demand model by layering different government policies onto it.
  • Introductory Question (iClicker): Which would you prefer: a tax on gasoline or a tax on oil company profits? (Most commonly preferred: tax on oil company profits. This chapter will explore why the incidence of the tax might be different from common intuition.)
  • Topics Covered: The chapter will first delve into taxes, then move on to subsidies.

Taxes: Core Concepts

  • Tax Wedge: The primary impact of a tax is the creation of a "tax wedge," which is a difference between the price buyers pay and the price sellers receive.
    • Before Tax: In a market equilibrium, the equilibrium price is the price buyers pay and the price sellers receive.
    • After Tax: With a tax, this is no longer the case. Buyers pay a higher price, and sellers receive a lower price (after remitting the tax).
  • Key Insight (Spoiler Alert): It does not matter whether the tax is legally imposed on buyers or sellers; the economic outcome, including the price buyers pay, the price sellers receive, and the quantity traded, will be the same.
  • Elasticity and Tax Incidence (Spoiler Alert): The concept of "elasticity equals escape" is crucial. The side of the market that is more price sensitive (more elastic, with more substitutes) can more easily escape the tax burden. Conversely, the side that is less price sensitive (more inelastic) will bear a larger share of the tax burden.
  • Deadweight Loss and Inefficiency: A tax will lead to fewer transactions being made than what would occur in an efficient market equilibrium. This reduction in transactions indicates an inefficiency or deadweight loss.

Types of Taxes Analyzed: Simple Taxes (Excise Taxes)

  • Definition: A "simple tax" refers to a fixed dollar amount per unit traded ( \$X per unit), rather than a percentage of the transaction value.
    • Reason for Focus: Percentage taxes lead to curvilinear demand/supply curves, making graphical and mathematical analysis more complex. Therefore, the course will focus on simple dollar-per-unit taxes.
  • Examples of Excise Taxes:
    • Gasoline: Cents per gallon traded.
    • Cigarettes: Dollars per pack/carton traded.
    • Alcohol: Specific amount per unit traded.
  • Application to Labor Market: Payroll taxes (e.g., Social Security taxes) can be analyzed using this model. In the labor market, individuals are the suppliers of labor, and firms are the consumers (demanders) of labor.
  • Where the Model Doesn't Apply: This analysis specifically excludes property taxes or wealth taxes because these are not based on unit-by-unit transactions (e.g., annual property tax on a car or house, which is not bought/sold annually).

Analyzing a Tax on Producers (Example: Tofu)

  • Scenario: A \$1 tax is placed on producers of tofu.
  • Impact on Supply: The tax increases producers' costs, effectively decreasing supply. This shifts the supply curve to the left by the size of the tax ( \$1 ).
  • New Equilibrium and Price Changes (Illustrative Numbers):
    • Original Equilibrium (Point A): Price = \$2.00 . Quantity = Q_1 . (Both buyers and sellers dealt at this price.)
    • New Equilibrium (Point B) after tax on producers:
      • The price buyers pay (P_B) increases to \$2.40 . This means buyers pay an additional \$0.40 compared to the original price.
      • The price sellers receive (P_S) after remitting the tax is \$1.40 . (They collect \$2.40 from the buyer but must send \$1.00 to the government, so their net receipt is \$2.40 - \$1.00 = \$1.40 ). This means sellers receive \$0.60 less than the original price.
  • Tax Burden Distribution:
    • Buyers' Burden: P_B - \text{Original Price} = \$2.40 - \$2.00 = \$0.40 .
    • Sellers' Burden: \text{Original Price} - P_S = \$2.00 - \$1.40 = \$0.60 .
    • Total Tax: \$0.40 + \$0.60 = \$1.00 , which matches the imposed tax.
  • Conclusion: Even though the tax was placed on producers, both buyers and sellers share the burden. In this example, sellers bore \$0.60 of the tax, while consumers bore \$0.40 .

Analyzing a Tax on Consumers (Example: Car Sales Tax)

  • Scenario: A \$1 tax is placed on consumers (e.g., car sales tax where the buyer pays the state directly).
  • Impact on Demand: The tax increases the effective price for consumers, decreasing demand. This shifts the demand curve to the left by the size of the tax ( \$1 ).
  • Key Outcome: The resulting prices paid by buyers and received by sellers, and the new quantity traded, are identical to the scenario where the tax was placed on producers. The economic incidence is the same regardless of the legal incidence.

The Tax Wedge Method (Graphical Shortcut)

  • Instead of shifting curves, a simpler approach is to draw a "tax wedge" directly on the original supply and demand graph.
  • Procedure: Draw a vertical line segment (the tax wedge) with a length equal to the tax amount (e.g., \$1 ) between the supply and demand curves, to the left of the original equilibrium (as taxes reduce transactions).
  • Interpreting the Wedge:
    • The point where the top of the tax wedge touches the demand curve indicates the price buyers pay ( P_B ).
    • The point where the bottom of the tax wedge touches the supply curve indicates the price sellers receive ( P_S ).
    • The vertical distance between PB and PS must equal the size of the tax. If it doesn't, the wedge is placed incorrectly.
  • Reduced Transactions: The horizontal position of the tax wedge indicates the new, lower quantity of transactions ( Q_2 ).

Tax Revenue and Burden Visualization

  • Government Tax Revenue: Represented by the rectangle formed by the tax wedge's height (the tax amount) and the new quantity of transactions ( Q_2 ).
    • \text{Tax Revenue} = \text{Tax Amount} \times Q_2
  • Distribution of Tax Revenue (Who Pays What):
    • Buyers' Share: The upper part of the tax revenue rectangle, extending from the original equilibrium price up to the price buyers pay ( P_B ).
    • Sellers' Share: The lower part of the tax revenue rectangle, extending from the original equilibrium price down to the price sellers receive ( P_S ).
  • Tax Incidence Definition: The actual division of the burden of a tax between buyers and sellers, which depends on relative elasticities, not the legal assignment of the tax.

The Role of Relative Elasticities in Tax Incidence

  • "Elasticity Equals Escape": The more elastic side of the market has more flexibility to adjust its behavior (e.g., find substitutes, change production), allowing them to "escape" more of the tax. The more inelastic side has fewer alternatives and thus bears a greater burden.
  • Graphical Illustration:
    • Scenario 1: Elastic Demand, Inelastic Supply (e.g., Tofu Example):
      • A relatively flat demand curve (elastic) and a relatively steep supply curve (inelastic).
      • Consumers (demand side) are more sensitive to price changes and have more substitutes, so they escape more of the tax burden.
      • Producers (supply side) are less sensitive, so they bear a larger share of the tax burden.
      • The price buyers pay increases only slightly; the price sellers receive drops significantly.
    • Scenario 2: Inelastic Demand, Elastic Supply:
      • A relatively steep demand curve (inelastic) and a relatively flat supply curve (elastic).
      • Producers (supply side) can easily adjust to price changes (e.g., exit the market), so they escape more of the tax burden.
      • Consumers (demand side) are less sensitive and have fewer alternatives, so they bear a larger share of the tax burden.
      • The price buyers pay increases significantly; the price sellers receive drops only slightly.
  • Conclusion: The common belief that businesses simply pass all taxes onto consumers is a myth. The burden is split based on the relative elasticities of supply and demand.

Applications of Tax Incidence

  • Cigarette Tax:
    • Demand: Generally considered inelastic (addictive product, fewer substitutes for smokers), implying consumers will bear a significant portion of the tax.
    • Supply: Can be relatively elastic at a state level (producers can shift production to states with lower taxes).
    • Policy Implication: For an effective reduction in smoking, a federal (nationwide) or global tax would be more effective by reducing suppliers' ability to escape.
  • Health Insurance / Labor Tax (e.g., Social Security, Medicare):
    • Labor Supply (Individuals): Often inelastic (it's hard to learn a new language and move countries just to avoid a federal tax).
    • Labor Demand (Firms): Can be more elastic (firms have alternatives like machinery, or they can relocate).
    • Incidence: The burden of federal labor taxes tends to fall more heavily on the sellers of labor (individuals).
  • Long-Distance Relationships (Metaphor): The person with fewer desirable alternatives (e.g., fewer options at their location) will bear a disproportionate share of the 'cost' or 'burden' of the relationship (e.g., driving more).

Polar Cases of Elasticity

These extreme scenarios demonstrate the principles of tax incidence clearly:

  • 1. Perfectly Elastic Demand (Horizontal Demand Curve):
    • Buyers are extremely price sensitive; any price increase leads to zero demand.
    • When a tax is imposed, the quantity traded decreases ( Q1 \to Q2 ), but the price buyers pay ( P_B ) remains unchanged (at the original equilibrium price).
    • Incidence: The seller pays the entire tax. They receive a price equal to the original equilibrium price minus the tax amount.
  • 2. Perfectly Inelastic Supply (Vertical Supply Curve):
    • The quantity supplied is fixed and does not change with price.
    • When a tax is imposed, the quantity traded ( Q_1 ) remains unchanged.
    • Incidence: The seller pays the entire tax. The price buyers pay appears to be the original price plus the tax amount, but the net price received by the seller is the original equilibrium price minus the tax. Essentially, the seller absorbs the entire tax because they cannot change the quantity supplied to escape.
  • Summary of Polar Cases and Incidence:
    • Seller Pays All Tax: When demand is perfectly elastic OR supply is perfectly inelastic.
    • Consumer Pays All Tax: When demand is perfectly inelastic OR supply is perfectly elastic.

Historical Footnote: Land Tax Reformers

  • Context: In the 19th century, land was a primary store of wealth.
  • Supply of Land: Generally considered perfectly inelastic (vertical supply curve) because the quantity of land is fixed (cannot be created).
  • Tax Reformers' Argument: They heavily promoted a land tax because, given an inelastic supply of land:
    • The tax burden would fall almost entirely on the wealthy landowners (the sellers).
    • It would not deter or reduce the number of land transactions, thus avoiding deadweight loss in that market.
    • This was seen as a fair and efficient way to tax wealth without causing significant economic distortion.