An Ad Valorem Tax
Statutory distinction between employers and
employees is irrelevant.
Economic incidence depends on elasticity of
Supply and Demand.
e.g.: If labor supply is perfectly inelastic workers
pay all of tax regardless of statutory incidence.
Like other taxes--Draw S & D, statutory incidence determines
which curve moves.
Shift if unit tax.
Pivot if ad valorem tax.
Open Economy: Normal S & D
owners of capital will bear part of tax
Open Economy, perfectly mobile capital: S is perfectly elastic.
Capitalists bear no tax.
Generally, the more open the economy the better able
capitalist are to avoid tax.
Tax on Monopoly
Previously looked at competitive models.
Unit tax on good sold by monopolist.
Shifts D & MR down by amount of tax.
Leads to decrease in quantity.
Consumers pay more, monopolist nets less.
Despite its power, monopolists can suffer from
Taxation of Oligopolist
Incidence depends on how prices change.
Economists don’t have a single, generally accepted model of
how oligopolists set prices.
Therefore, economists are uncertain about tax incidence under
However, for an oligopolist the best thing they can do is form a
cartel and increase there profits by acting like a monopolist.
(restrict Q, increase P)
To the extent taxes cause oligopolies to cut back on output,
they move closer to the cartel solution. This causes their
before-tax profits to increase--perhaps by enough to completely
offset the burden of the tax.
Remember Economic profits are
supranormal or excess accounting profits.
A profit tax has no affect on MR or MC.
Thus the firm won’t change Q or P.
Therefore, profit taxes are completely
absorbed by firms.
With no economic distortions, the tax is
May be hard to implement because you would need
to determine normal profits.
Land Taxes and Capitalization
Land is durable and fixed in supply.
In competitive markets the price of land
should reflect the present value of a stream
of after-tax rents.
When the tax is imposed the price of land
falls by the PV of all future tax payments.
This process is called capitalization.
The burden of the tax forever is on whoever
owns the land at the time the tax is
Have been looking at only one market--partial
Now want to look at how, for example, a tax in
the auto industry will affect the markets for steel
To keep it simple we will look at a world where
there is no savings and only two commodities
(food and manufactures) and two factors of
production (capital and labor).
Partial Factor taxes:
tKF = tax on capital used to make food.
also: tKM, tLF, tLM.
Any two sets of taxes that generate the
same change in relative prices have
equivalent incidence effects.
A tax on both goods is the same as an
A tax on both factors in an industry is the
same as a consumption tax on that industry.
A partial factor tax on one factor in both
industries is the same as a general factor
Constant Returns to Scale
One industry is capital intensive the other labor
Perfect factor mobility
Competitive profit maximizers
Fixed amount of capital and labor
Consumers have identical preferences.
Look at differential tax incidence
A Commodity tax: tF
Increases relative price of food, people buy less
food, more manufactures.
Some of the K & L used in food production goes
into manufactures production.
If food is relatively more capital intensive, then the
only way the manufacturing sector will absorb lots
of capital is if the price of capital falls in both
More generally, a tax on the output of a particular
sector will hurt all of the suppliers of the input used
intensively in that sector.
Commodity Tax (cont.)
Things which increase the damage done to
capitalists by a tax on food.
The more elastic the demand for food.
The greater the difference in K/L ratios between the food
and manufactures sectors.
The harder it is to substitute capital for labor in the
Because capitalists and laborers have identical
preferences, we don’t need to look at the tax effects
on the uses side of the budget.
Income Tax (t): Factor supplies are by
assumption fixed. Thus, this tax burden
cannot be shifted. The burden falls in
proportion to people’s incomes.
Tax on Labor (tL) Since both sectors are
taxed, labor won’t migrate between sectors.
Since labor supply is fixed (inelastic), workers
bear full burden of tax
Partial Factor Tax (TKM)
Output Effect: The price in the taxed sector (manufactures)
will rise causing a decrease in the quantity demanded by
Will decrease the relative price of the intensively
Factor Substitution Effect: The price on the taxed factor
(capital) will increase causing the manufacturing sector to use
less capital and more labor.
If Manufacturing is capital intensive, both effects work in the
same direction, and the relative price of capital must fall. If
Manufacturing is labor intensive, the net result is theoretically
ambiguous. This partial factor tax could actually hurt labor.
Hurts capital as long as labor can be substituted for
Changing the Assumptions
Different Consumer tastes: Affects distribution on uses
For example, if capitalists consume a lot of manufactures and
these goods are labor intensive, then a tax on capital may
Mobility of Factors: If a factor is immobile, the taxed factor
will bear the entire burden of a partial factor tax. It cannot
escape the tax by migrating to another sector.
Variability of factors: If factors are variable, then in the long
run, less of the taxed factor will be supplied.
For example, if capital is taxed, less will be supplied in long
run, this will increase returns to capital, and weaken the
returns to labor. That is, in the long run, some of the tax can
be shifted onto labor.