A-Level Economics Notes on Tax Incidence

Definitions

1. Tax Incidence: The study of who bears the relative burden of a new or existing tax. It’s not just an accounting exercise but an analytical characterization of changes in economic equilibria when taxes are altered.
2. Economic Equilibrium: The state where supply equals demand in a market.
3. Incidence of Tax on Producer: A tax levied on the producer affects the price level and equilibrium quantity in the market.
4. Consumer Burden: The portion of the tax that consumers end up paying.
5. Producer Burden: The portion of the tax that producers end up paying.
6. Elasticity: A measure of how much quantity demanded or supplied responds to a change in price.
7. Inelastic Demand/Supply: When the quantity demanded/supplied is less responsive to price changes.
8. Elastic Demand/Supply: When the quantity demanded/supplied is more responsive to price changes.
9. Welfare Economics: The study of how the allocation of resources affects economic well-being.
10. Efficiency Costs of Taxation: The costs associated with the changes in resource allocation that taxes cause.
11. Social Stratum: Different levels of income groups in society, often analyzed to understand the distributional effects of taxation.

Diagrams

Figure 1: Tax incidence at different levels of elasticity

 <h2> Tax Incidence

Tax Incidence: Refers to how the burden of a tax is distributed between consumers and producers.

Consumer Burden

• Consumer Surplus: The extra benefit consumers get from buying a product.
• Elasticity: Determines how much of the tax consumers will bear. More elastic demand means less burden on consumers.

Producer Burden

• Producer Surplus: The extra benefit producers get from selling a product.
• Elasticity: More elastic supply means less burden on producers.

Deadweight Loss

• Deadweight Loss: The loss in consumer and producer surplus due to the tax.

Types of Taxes

• Ad Valorem Tax: A percentage of the price.
• Specific Tax: A fixed amount per unit.

Government Revenue

• Tax Revenue: The money collected by the government, which can be affected by the elasticity of demand and supply.

Equilibrium

• New Equilibrium: After tax, the market reaches a new equilibrium where the price is higher and the quantity is lower.

Factors Affecting Incidence

• Market Structure: In a monopoly, the incidence can be different.
• Time: Over time, supply and demand may become more elastic, changing the tax incidence.

Consumer Burden

Consumer burden refers to the portion of a tax that consumers end up paying. It’s a part of the overall tax incidence.

Consumer Surplus: This is the extra benefit that consumers get from buying a product at a price lower than they’re willing to pay. A tax reduces consumer surplus[3].

Factors Determining Consumer Burden

1. Price Elasticity of Demand:
   • Elastic Demand: When demand is elastic, consumers are more sensitive to price changes. They will bear less of the tax burden.
   • Inelastic Demand: When demand is inelastic, consumers are less sensitive to price changes. They will bear more of the tax burden.
2. Necessity vs. Luxury:
   • Necessity: For essential goods, demand is usually inelastic, leading to a higher consumer burden.
   • Luxury: For non-essential goods, demand is often elastic, resulting in a lower consumer burden.
3. Availability of Substitutes:
   • More Substitutes: The more substitutes available, the more elastic the demand, reducing consumer burden.
   • Fewer Substitutes: The fewer substitutes, the more inelastic the demand, increasing consumer burden.
4. Time Horizon:
   • Short-term: Demand is usually more inelastic in the short term.
   • Long-term: Over time, consumers find alternatives, making demand more elastic and reducing consumer burden.
5. Market Structure:
   • Competitive Markets: In competitive markets, consumers have more choices, making demand more elastic.
   • Monopoly: In a monopoly, consumers have fewer choices, making demand more inelastic and increasing consumer burden.

Producer Burden

Producer burden refers to the portion of a tax that producers end up paying. It’s part of the overall tax incidence.

1. Producer Surplus: This is the extra benefit that producers get from selling a product at a price higher than their minimum acceptable price. A tax reduces producer surplus[6].

Factors Determining Producer Burden

1. Price Elasticity of Supply:
   • Elastic Supply: When supply is elastic, producers can easily adjust their production, bearing less of the tax burden.
   • Inelastic Supply: When supply is inelastic, producers find it hard to adjust, bearing more of the tax burden.
2. Production Costs:
   • High Costs: Higher production costs make it difficult for producers to absorb the tax, increasing their burden.
   • Low Costs: Lower costs allow producers to absorb the tax more easily, reducing their burden.
3. Market Structure:
   • Competitive Markets: In competitive markets, producers have less pricing power, making it harder to pass on the tax to consumers.
   • Monopoly: In a monopoly, the producer has more pricing power and can pass more of the tax onto consumers.
4. Time Horizon:
   • Short-term: Supply is usually more inelastic in the short term, increasing the producer burden.
   • Long-term: Over time, producers can adjust their production methods, making supply more elastic and reducing their tax burden.
5. Availability of Substitutes for Inputs:
   • More Substitutes: The more substitutes available for production inputs, the easier it is for producers to adjust, reducing their tax burden.
   • Fewer Substitutes: Fewer substitutes make it harder to adjust, increasing the tax burden on producers.