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Does Congress decide who pays the
taxes?
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Taxes
8
CHAPTER CHECKLIST

When you have completed your

study of this chapter, you will be able to

1 Explain how taxes change prices and quantities, are

shared by buyers and sellers, and create inefficiency.
2 Explain how income taxes and Social Security taxes
change wage rates and employment, are shared by
employers and workers, and create inefficiency.
3 Review ideas about the fairness of the tax system.

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8.1 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.

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8.1 TAXES ON BUYERS AND SELLERS

The tax is like a wedge between the two prices.

Suppose that the government puts a $10 tax on
smartphones.
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?

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8.1 TAXES ON BUYERS AND SELLERS

Figure 8.1(a) shows

what happens when
the government taxes
buyers of the
smartphones.
1. With no tax, the
price is $100 and
5,000 smartphones
are bought.
2. A $10 tax on buyers
shifts the demand
curve to D – tax

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8.1 TAXES ON BUYERS AND SELLERS

3. The buyer’s price

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

Figure 8.1(b) shows what

happens when the
government taxes sellers
of the smartphones.
1. With no tax, the price
is $100 and 5,000
smartphones a week
are bought.
2. A $10 tax on sellers
of smartphones shifts
the supply curve to
S + tax.

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8.1 TAXES ON BUYERS AND SELLERS

3. The buyer’s price

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

Taxes and Efficiency

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.

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8.1 TAXES ON BUYERS AND SELLERS

Figure 8.2 shows the

inefficiency of taxes.
In Figure 8.2(a),
1. the market is efficient
with marginal benefit
equal to marginal cost.
Total surplus—the sum of
2. Consumer surplus and
3. Producer surplus—is
maximized.

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8.1 TAXES ON BUYERS AND SELLERS

Figure 8.2(b) shows how

taxes create inefficiency.
A $10 tax shifts the
supply curve to
S + tax.
1. Marginal benefit
exceeds
2. Marginal cost.
3. Consumer surplus
shrinks.
4. Producer surplus
shrink.
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8.1 TAXES ON BUYERS AND SELLERS

5. The government
collects tax revenue.
6. A deadweight
loss arises.
The loss of consumer
surplus and producer
surplus is the cost of
the tax.
The cost of the tax equals
the tax revenue plus the
deadweight loss.

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8.1 TAXES ON BUYERS AND SELLERS

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
cost of the tax
exceeds the tax
revenue received by
the government.
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8.1 TAXES ON BUYERS AND SELLERS

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.
The more inelastic the demand or the supply, the smaller
is the excess burden.

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8.1 TAXES ON BUYERS AND SELLERS

Incidence, Inefficiency, and the Elasticity of

Demand
Perfectly Inelastic Demand: Buyer Pays and Efficient
Perfectly Elastic Demand: Seller Pays and Inefficient
Figures 8.3(a) and 8.3(b) illustrate these two extreme
cases.

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8.1 TAXES ON BUYERS AND SELLERS

Figure 8.3(a) 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.

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8.1 TAXES ON BUYERS AND SELLERS

Figure 8.3(b) 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.

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8.1 TAXES ON BUYERS AND SELLERS

Incidence, Inefficiency, and the Elasticity of

Supply
Perfectly Inelastic Supply: Seller Pays and Efficient
Perfectly Elastic Supply: Buyer Pays and Inefficient
Figures 8.4(a) and 8.4(b) illustrate these two extreme
cases.

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8.1 TAXES ON BUYERS AND SELLERS

Figure 8.4(a) 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.
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8.1 TAXES ON BUYERS AND SELLERS

Figure 8.4(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.

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

Tax Rates
• Personal income tax
• Corporate income tax
• Social Security tax
Income taxes and Social Security taxes raise three-
quarters of total government revenue.
Congress sets the tax rates, but who pays the taxes?

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

The Effects of the Income Tax

Tax on Labor Income
Firms can substitute machines for labor, so the demand
for labor is elastic.
Most people must work for their income, so the supply of
labor is inelastic.
With elastic demand and inelastic supply, the worker
bears the greater burden of the income tax.

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

Figure 8.5 shows the

effects of a tax on labor
income.
1. A 20 percent
marginal tax rate
on labor income
decreases the
supply of labor to
LS + tax.
The wage rate rises,
and the after-tax wage
rate falls.

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

2. The employer pays

some of the tax.
3. The worker pays most
of the tax.
4. A deadweight loss
arises.

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

Tax on Capital Income

Taxing the income from capital works like taxing the
income from labor.
One crucial difference: capital is internationally mobile
and so the supply of capital is highly elastic—perhaps
perfectly elastic.

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

Figure 8.6 shows the

effect of a tax on capital
income.
1. The supply of capital
is perfectly elastic.
2. With a 40 percent tax
on capital income,
the supply of capital
becomes KS + tax.

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

The interest rate rises.

3. Firms pay the entire
tax.
4. A large deadweight
loss arises.

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

Tax on Income from Land and Unique Resources

Works in the same way as taxing the income from other
sources except for one crucial difference.
The supply of land is highly inelastic.
The tax on land income is paid by the landowners and
the quantity of land is unaffected by the tax.
With no change in the quantity of land, the tax on land
income creates no deadweight loss or excess burden
and is efficient.

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

Figure 8.7(a) shows a

tax on land income.
1. Supply is perfectly
inelastic.
2. With a 40 percent
tax, the supply of
land is unchanged
and the market rent
is unchanged.
3. The landowner pays
the entire tax.
No deadweight loss arises—the tax is efficient.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX

Figure 8.7(b) shows tax

on Bradley Cooper’s
income.
1. He makes 3 movies a
year and his supply
of services is
perfectly inelastic.

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

2. With a 40 percent
tax, the supply of
Bradley’s services is
unchanged and
Bradley’s fee is
unchanged.
3. Bradley pays the
entire tax.
No deadweight loss
arises and the tax is
efficient.

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

The Social Security Tax

The Social Security tax law says that the tax is to be
shared equally by workers and employers.
But the principles that determine the incidence of other
taxes you’ve studied in this chapter also apply to the
Social Security tax.
Figure 8.8 on the next slide illustrates the effects of a
Social Security tax.

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

With no tax, the wage rate

is $12.00 an hour and
4,000 people are hired.
Suppose that the Social
Security tax is set at
$2.50 per hour.
The LS curve tells us the
wage rate that employers
are willing to pay.
The LD curve tells us the
wage rate that workers are
willing to accept.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX

How many workers get

employed?
The number of workers at
which the gap between the
wage rate employers pay
and the worker receive
equals $2.50 an hour.
1. A Social Security tax
equals the gap between
the LS curve and the LD
curve.
The workers hired
decreases to 3,000.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX

2. The wage rate paid

by employers rises
to $12.50 an hour—
an increase of
50¢ an hour.
3. The wage rate
received by
workers falls to
$10.00 an hour —a
drop of $2 an hour.
4. The government
collects tax
revenue.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX

With the $2.50

Social Security tax,
employers pay 50¢
an hour and workers
pay $2 an hour.

Workers pay most of

the tax because the
demand for labor is
more elastic than the
supply of labor.

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8.3 FAIRNESS AND THE BIG TRADEOFF

Whenever political leaders debate tax issues, it is

fairness, not efficiency, that looms above all other
considerations.
There are two conflicting principles of fairness of taxes:
• The benefits principle
• The ability-to-pay principle

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8.3 FAIRNESS AND THE BIG TRADEOFF

The Benefits Principle

The benefits principle is the proposition that people
should pay taxes equal to the benefits they receive from
public goods and services.
This arrangement is fair because it means that those
who benefit most pay the most.
But to implement it, we would need an objective way of
measuring each person’s marginal benefit from public
goods and services.

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8.3 FAIRNESS AND THE BIG TRADEOFF

The Ability-to-Pay Principle

The ability-to-pay principle is the proposition that
people should pay taxes according to how easily they
can bear the burden.
A rich person can more easily bear the burden of
providing public goods than can a poor person, so the
rich should pay higher taxes than the poor.
This principle compares people according to
• Horizontal equity
• Vertical equity

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8.3 FAIRNESS AND THE BIG TRADEOFF

Horizontal equity is the requirement that taxpayers with

the same ability to pay should pay the same taxes.
Vertical equity is the requirement that taxpayers with a
greater ability to pay bear a greater share of the taxes.

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8.3 FAIRNESS AND THE BIG TRADEOFF

The relationship between tax rates and income levels

depends on the degree of tax progressivity.
To describe tax progressivity, we use two tax rates:
The average tax, which is the percentage of income
paid in tax.
A marginal tax , which is the percentage of an
additional dollar of income paid in tax.
When the tax is progressive, the marginal tax rate
exceeds the average tax rate.

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8.3 FAIRNESS AND THE BIG TRADEOFF

A tax can be progressive, proportional, or regressive

A progressive tax is a tax whose average rate
increases as income increases.
A proportional tax is a tax whose average rate is the
same at all income levels.
A regressive tax is a tax whose average rate decreases
as income increases.

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8.3 FAIRNESS AND THE BIG TRADEOFF

The Big Tradeoff

Questions about the fairness of taxes conflict with
efficiency questions and create the big tradeoff.
Taxes on capital incomes create the greatest deadweight
loss—are the most inefficient.
But most of the capital is owned by a small number of
rich people, so (most people believe) taxes on capital
are the fairest.
Our tax system is an evolving attempt to juggle the two
goals of efficiency and fairness.

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Congress says that employers and workers pay
the same Social Security tax contributions (7.65
percent each in 2015).
But because the elasticity of demand for labor is
much greater than the elasticity of supply of labor,
workers end up paying most of the Social
Security tax.
But there is one thing that Congress can do to
influence who pays a tax.
It can pass a tax law (or tax rebate law) that
doesn’t impact the margin on which decisions
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On February 17, 2009, the President signed the
American Recovery and Reinvestment Act.
Among the Act’s many provisions is a “Making
Work Pay” tax credit of $400 for a single worker
and $800 for a couple.
A tax credit is a fixed reduction in the amount paid
in personal income tax (in the current case,
$400).
For most people, a tax credit has no effect on
their supply of labor.
The tax credit doesn’t influence the work-hours
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A 20% income tax rate
shifts the labor supply
curve from LS to LS +
tax.
The pre-tax wage rises

by $1 to $20 per hour,

the after-tax wage falls
by $3 to $16 per hour,
and
the workweek falls Copyright © 2018, 2015, 2013 Pearson Education, Inc. All Rights Reserved
Suppose that Congress
now passes an Act that
gives workers a tax
credit of $30 a week.
Tax paid by workers
falls.
Marginal tax rate
remains at 20%, but
now workers pay only
68% of the tax and
employers pay 32%.
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