Econ 551 Government Finance: Revenues Fall 2019 Given by Kevin Milligan Vancouver School of Economics University of British Columbia Lecture 6: Tax Incidence 1 of 45 ECON 551: Lecture 6
Agenda: 1. Overview 2. Basic Analysis 3. Harberger (1962) 4. Fiscal Incidence 5. Applied Policy Analysis Practice 2 of 45 ECON 551: Lecture 6
Overview “ Economics is at its best when it offers important insights that contradict initial, casual impressions. The theory of tax incidence provides a rich assortment of such insights .” Larry Kotlikoff Larry Summers Handbook of Public Economics, Volume 2, Chapter 16, 1987. 3 of 45 ECON 551: Lecture 6
Overview When taxes are levied, who really pays them? The producer? The consumer? Someone else? Tax incidence lies behind several policy debates in Canada in recent memory The HST. During the 2011 HST referendum in BC, there was great debate about whether and to what extent the old PST embedded in prices was passed on to consumers. Corporate taxes. Populists seem to believe, at the same time, that taxes on corporations should go up, but also that companies often pass on tax increases to consumers. Dots should be connected… Carbon taxes / cap and trade. Very little of carbon pricing affects retail market; most is intermediate production. Therefore, incidence assumptions are critical. o [Q: how do we justify carbon taxes if the Diamond-Mirrlees production efficiency lemma which said not to tax intermediate inputs?] 4 of 45 ECON 551: Lecture 6
Agenda: 1. Overview 2. Basic Analysis 3. Harberger (1962) 4. Fiscal Incidence 5. Applied Policy Analysis Practice 5 of 45 ECON 551: Lecture 6
Basic Analysis What is the definition of tax incidence? Fullerton and Metcalfe: “analysis of the impact of taxes on the distribution of welfare within a society.” Economists draw a distinction between who is legally obligated to remit the tax and those who actually lose economic welfare as a result of the tax. Here are the terms we use: Statutory incidence The legally obligated payer. The person who’s welfare changes. Economic incidence Standard result: economic incidence independent of statutory incidence. 6 of 45 ECON 551: Lecture 6
Passing the incidence of a tax If there is a difference between statutory and economic incidence, the difference is said to be passed on to other economic agents. If a tax on a commodity results in the firm paying lower input prices (e.g. lower profits on capital, lower wages on labour) then we say the tax was passed backwards. If, on the other hand, the tax results in higher prices for the output, we say the tax was passed forwards to consumers. 7 of 45 ECON 551: Lecture 6
Finding some fuzziness in tax incidence concept Another key question is to dig into what exactly the conceptual experiment is that we have in mind. There are three possibilities: a) Absolute incidence . What is the effect of imposing the tax, assuming that the government just keeps the revenue (or buries it or doesn’t use it in any way). b) Balanced -budget incidence. Assume that the government spends the new tax revenue; adjust incidence analysis for the effect of the spending. c) Differential incidence. Reduce some other tax as the tax under consideration is raised. Of course, this then muddies the water so you are analyzing two tax changes at once. So, the question of the incidence of one particular tax is not well-posed. What this makes clear is that the definition of the exercise is not terribly clear. 8 of 45 ECON 551: Lecture 6
The basic partial equilibrium diagram A tax levied on consumers. Price S 0 tax P 0 P 1 D 0 D 1 Q 0 Q 1 Quantity 9 of 45 ECON 551: Lecture 6
A tax levied on producers. Price S 1 S 0 tax P 1 P 0 D 0 Q 0 Q 1 Quantity 10 of 45 ECON 551: Lecture 6
The basic partial equilibrium analysis Notice that the price increase is less than the amount of tax. So, the suppliers ‘eat’ some of the tax increase and pass some of it on to consumers. Note that a supply shift responding to the tax on supply does the same thing. So, statutory incidence does not matter. Note the dependence of the degree of shifting on the elasticities of demand and supply. If supply is perfectly elastic, then price doesn’t go up; suppliers eat the difference. If demand is perfectly inelastic, they pay the full amount. o We can show this more formally… 11 of 45 ECON 551: Lecture 6
The basic partial equilibrium analysis Starting position: supply equals demand at price p , which is amount received by producers. 𝐸(𝑞) = 𝑇(𝑞) Now introduce tax t , with 𝑟 = 𝑞′ + 𝑢 which shifts equilibrium price to 𝑞 ′ . Assume consumer pays tax. 𝐸(𝑞 ′ + 𝑢) = 𝑇(𝑞 ′ ) Take derivative of equilibrium with respect to tax rate: 𝜖𝑞 ′ (𝜖𝑞 ′ 𝜖𝑞 ′ 𝜖𝐸 𝜖𝑢 + 1) = 𝜖𝑇 𝜖𝑢 . 𝜖𝑞 ′ Collect terms: 𝜖𝐸 𝜖𝑞 ′ 𝜖𝑞 ′ 𝜖𝑢 = (𝜖𝐸 𝜖𝑞 ′ − 𝜖𝑇 𝜖𝑞 ′ ) 12 of 45 ECON 551: Lecture 6
The basic partial equilibrium analysis: Let’s do an elasticity trick here: 𝑞 ′ 𝜁 𝐸 ≡ 𝜖𝐸 𝐸 𝜖𝑞 ′ 𝑞 ′ 𝜁 𝑇 ≡ 𝜖𝑇 𝑇 𝜖𝑞 ′ Substitute these elasticities into previous term: 𝜁 𝐸 𝐸 𝜖𝑞 ′ 𝑞 ′ 𝜖𝑢 = (𝜁 𝐸 𝐸 𝑞 ′ − 𝜁 𝑇 𝑇 𝑞 ′ ) Recognizing D=S gives: 𝜖𝑞 ′ 𝜁 𝐸 𝜖𝑢 = (𝜁 𝐸 − 𝜁 𝑇 ) 13 of 45 ECON 551: Lecture 6
Who bears the burden? 𝜖𝑞 ′ 𝜁 𝐸 𝜖𝑢 = (𝜁 𝐸 − 𝜁 𝑇 ) What happens to producer prices when demand elasticity is low? What happens to producer prices when supply elasticity is high? What happens to producer prices when supply elasticity is low? What happens to producer prices when supply elasticity is high? 14 of 45 ECON 551: Lecture 6
Extensions This analysis was obviously very simple. How could it be extended in interesting ways? General equilibrium analysis This is a method pioneered by John Whalley and others. Typically, you take a very simplified economy (e.g. two sectors, two factors, two outputs). Equilibrium conditions are set (equal returns after tax, risk adjusted in each sector for both labour and capital). The advantage is you can look at general equilibrium effects as the prices and quantities are determined endogenously. The disadvantage is that you have to choose a particular functional form for preferences and technology and other factors. For example, if you assume that capital is mobile internationally (and therefore supplied elastically) then you get very different results than if you assume that there is a fixed amount of capital. 15 of 45 ECON 551: Lecture 6
Extensions Imperfect competition In models of imperfect competition, you can actually have overshifting. That is, firms increase prices by more than the amount of tax. This happens because firms have some market power and want to try to recoup some of their lost revenue. To do so, they cut back on production and price can rise a lot, depending on the elasticities involved. A lot of empirical work finds evidence of over- shifting. However, in my quick look at it, I’m left wondering whether the finding in many of these cases is driven by a bad empirical design or by an actual over-shifting effect. 16 of 45 ECON 551: Lecture 6
Extensions Lifetime incidence analysis If you evaluate welfare over an entire lifetime rather than just at a point in time, you can get a very different picture. For example, think of a lifecycle savings model. At some stages, you have much income and less consumption. At other stages you have little income but a lot of consumption. Because of this, the distributional impact of a tax could be evaluated differently depending on which age you currently are. In a lifetime analysis, this wouldn’t be true. Intergenerational analysis Intergenerational analysis stacks lifetime analyses for different cohorts. This approach was pioneered by Auerbach and Kotlikoff, but Larry Kotlikoff has really pushed it for the last 20 years. This kind of approach is especially useful for tax and benefit policies that have strong intergenerational components such as Social Security or plans for public health spending. 17 of 45 ECON 551: Lecture 6
Agenda: 1. Overview 2. Basic Analysis 3. Harberger (1962) 4. Fiscal Incidence 5. Applied Policy Analysis Practice 18 of 45 ECON 551: Lecture 6
Harberger on the incidence of corporate taxes In Harberger (1962 JPE), he sets out a very simple general equilibrium model with two sectors (corporate, non-corporate) two inputs (labour, capital) two outputs (X,Y) He analyzes the impact of corporate taxation on his system. The corporate tax is assumed to be a tax on the return to capital invested in the corporate sector. 19 of 45 ECON 551: Lecture 6
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