3

CONT..

General Equilibrium Tax Incidence

So far, we have considered incidence in only
a single market, such as the gas market.
Partial equilibrium tax incidence:
Analysis that considers the impact of a tax
on a market in isolation.
General equilibrium tax incidence:
Analysis that considers the effects on
related markets of a tax imposed on one
market.
Taxes in one market affect prices in others,
complicating the analysis.
1

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CONT..

Effects of a Restaurant Tax: A General Equilibrium

Example

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CONT..

General Equilibrium Tax Incidence

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CONT..

Effect of Time Period on Tax Incidence: Short Run

versus Long Run
Factors that are inelastically demanded or
supplied in both the short and long run bear
taxes in the long run.
Investments are irreversible, so the supply
of capital is inelastic in the short run.
Investors have many opportunities, so in
the long run, elasticity of capital may be
high.

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CONT..

Effect of Tax Scope on Tax Incidence

Tax incidence depends on how broadly the
tax is applied.
Taxes that are broader based are harder to
avoid than taxes that are narrower, so the
response of producers and consumers to
the tax will be smaller and more inelastic.
A tax on local restaurants has a different
incidence than a tax on all restaurants.

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CONT..

Spillovers between Product Markets

Consider a tax on restaurant. A higher aftertax price has three effects on other goods as
well:
1.Income effect from lower real income.
2.Substitution effect toward goods that are
substitutes for restaurants.
3.Complementary effect: Consumers may
reduce their consumption of goods or services
that are complements to restaurant meals.

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CONT..

Conclusion
The fairness of any tax reform is one of
the primary considerations in policy
makers positions on tax policy.
Therefore, it is crucial for public finance
economists to have a deep understanding
of who really bears the burden of taxation
so that we can best inform these
distributional debates over the fairness of a
proposed or existing tax.

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CONT..
TaxInefficienciesandTheirImplicationsforOptimal
Taxation
1 Taxation and Economic Efficiency
2 Optimal Commodity Taxation
3 Optimal Income Taxes
4 Tax-Benefit Linkages and the Financing of
Social Insurance Programs

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CONT..
Tax Inefficiencies and Their Implications for Optimal
Taxation
Usually, the market produces efficient
outcomes.
Taxes interfere in the market and reduce
efficiency.
People substitute away from the taxed
product, using less-efficient alternatives.
o Eight-person motorcycles in Indonesia
Some taxes have much larger efficiency
costs than others.

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CONT..

Taxation and Economic Efficiency: Graphical Approach

S

Price per
gallon (P)

S
Tax =
$0.50
B

P2 =
$1.80
P1 =
$1.50
P3 =
$1.30

E
F

Deadweight
loss, DWL

D1

10

Q2 =
90

Q1 = 100

Quantity in
billions of
gallons (Q)
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CONT..

Taxation and Economic Efficiency

Absent taxes:
price = social marginal benefit = social
marginal cost
The tax drives a wedge between SMB and
SMC, preventing mutually beneficial trades
from occurring.
The units between 90 and 100 would have
generated a consumer and producer
surplus.
The foregone surplus from taxation is called
the deadweight loss (DWL).
11

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The size of the DWL depends on elasticities.

CONT..

Elasticities Determine Tax Inefficiency

Price per
gallon (P)

(a) Inelastic
demand

S
2

Tax

DWL
A

S
2

S
1

Tax

P2
P1

Price per
gallon (P)

(b) Elastic
demand

P2
P1

B
A
D

C
DWL

D
0

QQ
2

12

Quantity
in
billions
of
gallons
(Q)

Quantity in
billions of
gallons (Q)

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CONT..

Elasticities Determine Tax Inefficiency

Deadweight loss is caused by individuals
and firms making inefficient consumption
and production choices in order to avoid
taxation.
The inefficiency of any tax is determined by
the extent to which consumers and
producers change their behavior to avoid
the tax.
The more elastic is demand or supply, the
larger the DWL.
13

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CONT..

Determinants of Deadweight Loss

14

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CONT..

Marginal DWL Rises with Tax Rate

Price
of gas
P3

Tax =
$0.10

S
2

P2

P1

Tax =
$0.10
DWL

C
E
D1
0

15

Q3

Q2

Q1

Quantity of
gas

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CONT..

A Tax Systems Efficiency Is Affected by a Markets

Preexisting Distortions
Since marginal DWL rises with the tax rate,
pre-existing distortions affect the efficiency
of a new tax.
o Preexisting distortions: Market
failures, such as externalities or
imperfect competition, that are in place
before any government intervention.
o Externalities Imperfect competition,
existing taxes.

16

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CONT..

A Tax Systems Efficiency Is Affected by a Markets

Preexisting Distortions

17

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CONT..
Progressive Tax Systems Can Be Less Efficient:
Graphical Approach

18

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CONT..

Ramsey Taxation: The Theory of Optimal

Commodity Taxation

19

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CONT..

Inverse Elasticity Rule

20

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CONT..

Equity Implications of the Ramsey Model

Imagine that the government had only two
goods it could tax, X and Y:
Elasticity of demand for Y is much higher
than that for X.
The inverse elasticity rule would suggest
that the government tax X much more
highly than Y.
This means taxing the good consumed by
poor people more heavily.
This might hurt vertical equality.
21

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CONT..
APPLICATION: Price Reform in Pakistan

Commodities are taxed or subsidized

throughout the developing world.
Deaton (1997) studied the demand for
subsidized goods in Pakistan, looking at
their elasticity, and the income of people
who consume it.
Good
Subsidy Elasticity Consumed
by?

22

Wheat

40%

0.64

Poor

Rice

40%

2.08

All

Oil/Fat

5%

2.33

Poor
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CONT..

APPLICATION: Efficiency Consequences of Taxes

and Subsidies in Pakistan: Wheat (Inelastic Demand)

23

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CONT..

APPLICATION: Efficiency Consequences of

Subsidies in Pakistan: Wheat (Inelastic Demand)

24

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CONT..

APPLICATION: Efficiency Consequences of Subsidies

in Pakistan: Rice (Elastic Demand)

25

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CONT..

APPLICATION: Efficiency Consequences of Taxation

in Pakistan: Oils and Fats (Elastic Demand)

26

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CONT..

Optimal Income Taxes

27

Most tax revenue in the United States and

other developed countries is from income
taxes.

Optimal income taxation: Choosing the

tax rates across income groups to
maximize social welfare subject to a
government revenue requirement.

Social welfare function guides the trade-off

between progressivity and efficiency.

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CONT..

The Laffer Curve

28

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CONT..
The Laffer Curve
The Laffer Curve describes the relationship between the tax rate
and the tax revenue it generates
The Laffer Curve implies there is an optimal tax rate, a tax rate
that maximizes tax revenue.
The Laffer curve gets its name from economist Arthur

Laffer even though a 14th century Islamic scholar named

Ibn Khaldun first conceived it.

29

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CONT..
People will not work and firms will not produce anything if the tax
rate is 100%. If no one works and nothing is produce, the economy
generates no income. Hence,
People pay no income taxes when the tax rate is 0%.
Tax Revenue = 0
2.5

Tax Revenue

2.0

(in trillions of $)
1.5

1.0

0.5

0
30

20

40

60

tax rate (percent)

80

100

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CONT..
tax rate
If tax revenue is 0 when the tax rate is 0% or 100%, there is a tax
rate where
tax revenues
a maximum
where
tax revenues
reachreach
a maximum
value.value.
According to the diagram below, the optimal tax rate is 30%. This
2.5$2.5 trillion in tax revenue.
tax rate generates
2.5

Tax Revenue

2.0

(in trillions of $)
1.5

1.0

0.5

0
31

20

40

60

tax rate (percent)

80

100

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CONT..
If the tax rate is 60%, tax revenue is $1.7 trillion.
If the tax rate is cut to 30%, tax revenue increases to $2.5 trillion.
2.5
2.5

Tax Revenue
(in trillions of $)

2.0

1.7
1.5

1.0

0.5

0
32

20

30

40

60
60

tax rate (percent)

80

100

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CONT..
If the tax rate is 30%, tax revenue is $2.5 trillion.
If the tax rate is raised to 60%, tax revenue decreases to $1.7 trillion.
2.5
2.5

Tax Revenue
(in trillions of $)

2.0

1.7
1.5

1.0

0.5

0
33

20

30

40

60
60

tax rate (percent)

80

100

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CONT..
The Laffer Curve also suggests that when tax rates are too low, a
tax cut lowers tax revenue.
2.5

2.3
Tax Revenue
(in trillions of $)

2.0

1.6
1.5
1.0

0.5

0
34

20
10 20

40

60

tax rate (percent)

80

100

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CONT..
Tax-Benefit Linkages and the Financing of Social
Insurance Programs
So far we have ignored tax-benefit linkages.
Tax-benefit linkages: Direct ties between
taxes paid and benefits received.
Introducing these linkages enriches
changes the story, since many payroll taxes
are directly linked to benefits.

35

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CONT..
Tax-Benefit Linkages: Graphical Representation
Wage
Taxes

S1 =
SMC

C
G

S2

W1

Benefits
F

W2

B
E

D2
0
36

L2

L3 L1

D1 =
SMB
Quantity of labor
(L)
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CONT..
Tax-Benefit Linkages: Graphical Representation

37

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CONT..
Perfect Linkage Eliminates the DWL

38

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