Summary of Public Expenditure, Taxation, and Social Policy
Public Expenditure, Taxation, and Social Policy: A Student Guide
Introduction
Tax incidence and behavioral effects examine who ultimately bears the economic burden of a tax and how taxes change market behavior. This topic explores statutory incidence (who the law requires to pay) versus economic incidence (who actually bears the cost), and how market structure and price elasticities shape outcomes.
Definition: Statutory incidence is the party legally responsible for paying a tax; economic incidence is the party that actually bears the net economic burden after market adjustments.
1. Basic concepts and distinctions
Statutory vs economic incidence
- Statutory incidence: legal liability for remitting the tax (seller, buyer, firm, etc.).
- Economic incidence: final division of the tax burden between buyers and sellers after price and quantity adjust.
Definition: Economic incidence refers to the allocation of the tax burden between market participants after prices move and quantities change.
Key idea: The statutory payer is not always the same as the economic bearer. Markets reallocate burdens according to supply and demand responses.
Role of market structure
- Perfect competition: many small buyers and sellers; firms are price takers.
- Monopoly: a single price-setting firm; pricing decisions influence incidence.
2. How taxes shift supply and demand curves
- Unit (specific) tax on producers: supply curve shifts vertically upward by the tax amount (parallel shift) when expressed as price received by sellers.
- Ad valorem (percentage) tax on producers: supply curve swivels (non-parallel shift), because the tax amount increases with gross price.
Definition: A unit tax is a fixed amount per unit sold; an ad valorem tax is a tax equal to a percentage of the sale price.
Practical example: A $1 per-unit excise tax on cigarettes raises producers' marginal cost by $1 for every pack (parallel shift). A 10% sales tax increases the tax paid as price rises (non-parallel shift).
3. Tax incidence under perfect competition (increasing-cost industry)
- Assumptions: supply upward-sloping (increasing-cost industry), price-taking buyers and sellers.
- Unit tax: supply shifts up by $t$ (parallel). New equilibrium has higher buyer price and lower seller net price; the tax burden is split according to elasticities.
- Ad valorem tax: supply undergoes a swivel (non-parallel shift). Because the tax is a fraction of the gross price, the vertical distance between original and taxed supply curves increases with price.
Practical implication: With an ad valorem tax, higher-priced transactions generate larger absolute tax payments, and the division of burden depends on slope differences at the equilibrium.
Table: Unit vs Ad valorem tax effects
| Feature | Unit tax | Ad valorem tax |
|---|---|---|
| Shift of supply | Parallel upward (by $t$) | Non-parallel (swivel) |
| Tax amount per unit | Constant $t$ | Proportional to price (e.g., $\tau \cdot P$) |
| Incidence depends on | Elasticities at equilibrium | Elasticities and level of price |
4. Monopoly: incidence and taxation of profit
- Monopoly sets output where $MC = MR$ and chooses a price on the demand curve.
- A unit tax on producers raises marginal cost from $MC_0$ to $MC_1$ and average cost from $AC_0$ to $AC_1$ (parallel shifts). The monopolist reduces output and raises price.
Display math example (profit maximization before and after tax): $$MC_0 = MR\quad\text{before tax}$$ $$MC_1 = MR\quad\text{after tax}$$
- Because the monopolist is a price setter, some of the tax can be absorbed as lower profit rather than fully passed to consumers. That means monopolies do not always fully shift unit taxes onto buyers.
Alternative: taxing only economic profit (pure profit tax). If the government taxes only the monopoly's economic profit and not output o
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Tax Incidence Effects
Klíčové pojmy: Statutory incidence is legal liability; economic incidence is who actually bears the tax., Unit tax causes a parallel upward shift in supply by $t$; ad valorem tax causes a non-parallel swivel proportional to price., In perfect competition, incidence split depends on price elasticities of demand and supply., The less price-elastic side of the market bears the larger share of a tax., Monopoly faces parallel shifts in MC and AC with a unit tax; some burden can remain as lower profit., Taxing only economic profit leaves MC and AC unchanged and the monopoly bears the tax fully., Government revenue from a unit tax equals $t$ times the new traded quantity; ad valorem revenue depends on price level., Policy design should match tax base to elasticity: inelastic goods raise revenue with smaller quantity loss., Ad valorem taxes scale with price and affect tax paid per unit as price changes., Empirical evidence suggests redistribution is often more effective via expenditure than relying solely on tax progressivity.