Public Economics
Lecture: 08 Taxation II
Taxation of Goods and Services
Dr. Jonathan St¨abler
Masaryk University
Faculty of Economics and Administration
Fall 2024
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Outline of Lecture
1. The Three Rules of Tax Incidence
2. Welfare losses of Consumption Taxes
3. Substitution Effects
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Taxation of Goods and Services
Indirect Consumption Taxes:
▶ Sales tax: Charged on the final price paid by the consumer at the point of sale.
▶ VAT: Levied at each stage of production and distribution on the value added at
that stage.
▶ Excise tax: A specific type of tax targeting particular goods or services (fuel,
alcohol, tobacco, etc.).
−→ VAT and sales tax are calculated as a percentage of the monetary value of goods or
services.
−→ Excise taxes are often per-unit quantity taxes.
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Per-unit Taxes as a Simplification
As a simplification, we focus on a per-unit quantity tax:
▶ A fixed amount levied per unit of a good, regardless of its price.
▶ Example: $0.50 per liter of gasoline or $2 per pack of cigarettes.
▶ Tax is based solely on the quantity of goods sold.
→ Captures the important features of indirect consumption taxes.
→ Abstracts from features, which do not change the overall direction of the causal
effect.
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Outline of Lecture
1. The Three Rules of Tax Incidence
2. Welfare losses of Consumption Taxes
3. Substitution Effects
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The Three Rules of Tax Incidence
1. The statutory burden of a tax does not describe who really bears the tax.
2. The side of the market on which the tax is imposed is irrelevant to the distribution
of the tax burdens.
3. Parties with inelastic supply or demand bear taxes; parties with elastic supply or
demand avoid them.
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Tax Incidence
▶ Statutory Incidence: Refers to who legally pays the tax (e.g., producers of
gasoline, redistributors, sellers).
▶ Economic Incidence: Reflects the true burden of the tax, considering market
reactions and changes in available resources.
▶ Market Reaction: Taxes affect supply, demand, and prices, leading to a shift in
who actually bears how much of the tax burden.
Consumer tax burden
=(post-tax price - pre-tax price) + per-unit tax payments by consumers.
Producer tax burden
=(pre-tax price - post-tax price) + per-unit tax payments by producers.
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Statutory Burdens Are Not Real Burdens
Example: 50¢ per gallon tax on gasoline, to be paid by the producers.
Source: Gruber (2005)
Will gas producers receive 50¢
less on each gallon they produce
as a result of this tax?
− No, because of market
reactions (from A to D).
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Statutory Burdens Are Not Real Burdens
Example: 50¢ per gallon tax on gasoline, to be paid by the producers.
Source: Gruber (2005)
1. Tax effect: Producer have to pay the tax
per unit, hence production becomes more
’costly’. (S1 shifts to S2).
2. Market reaction: New equilibrium in D.
→ Less quantity produced
(from Q1 to Q3).
→ Market price rises
(from P1 to P3).
→ Consumers pay 30¢ more (P3 − P1).
→ Producers bear 20¢ of the tax
($1.8 − $1.30 − $0.5 tax).
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The Side of the Market is Irrelevant
Example: 50¢ per gallon tax on gasoline, to be paid by the consumers.
Source: Gruber (2005)
1. Tax effect: Product becomes more
expensive, consumers demand less for the
same ex-ante price (without tax).
(D1 shifts to D2)
2. Market reaction: New equilibrium in D.
→ Less quantity demanded (from Q1 to Q3)
→ The market price (without tax) falls
(from P1 to P3)
→ However, consumers pay 30¢ more because
they have to pay the tax
($1.50 − $1.30 + $0.50 tax).
→ Producers bear 20¢ of the tax (P1 − P3) .
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Elasticity of Demand
▶ Elasticity measures how sensitive the quantity demanded of a good is to changes in its price.
▶ It reflects the responsiveness of consumers: do they buy much less, or only slightly less,
when prices rise?
Types of Elasticity:
▶ Elastic Demand: Large changes in demand due to small price changes.
−→ e.g., easily substitutable products: soft drinks, airline tickets, luxury goods, etc.
▶ Inelastic Demand: Small or negligible changes in demand despite larger price changes.
−→ e.g., essential medicines, water, or electricity.
▶ Perfectly Elastic Demand: Demand drops to zero with any price increase.
−→ e.g., homogeneous products in a perfectly competitive market, e.g., gas at one specific
gas station.
▶ Perfectly Inelastic Demand: Demand remains unchanged regardless of price changes.
−→ e.g., life-saving drugs like insulin for diabetics.
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Elasticity Determines who Pays for the Tax
Source: Gruber (2005)
Perfectly inelastic demand:
−→ No change in demanded
quantity after price
increase.
−→ Consumers bear all the
burden of the tax.
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Elasticity Determines who Pays for the Tax
Source: Gruber (2005)
Perfectly elastic demand:
−→ No change in price after
tax, as consumers only
buy for P1.
−→ Producers bear all the
burden of the tax.
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Elasticity of Supply
▶ Measures how responsive the quantity supplied of a good is to a change in its price.
▶ It shows the flexibility of producers in adjusting production levels.
Types of Elasticity:
▶ Elastic supply: Producers can quickly increase supply in response to price changes.
−→ e.g., taxi rides (Uber/ Bolt), easily manufactured goods like pencils, plastic/
paper bags, etc.
▶ Inelastic supply: Quantity supplied is less responsive to price changes due to
constraints.
−→ e.g., agricultural products (it needs time and land to grow something),
electricity from nuclear reactors, etc.
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Elasticity of Supply also Matters
Source: Gruber (2005)
Inelastic supply (a):
−→ small price changes,
producers bear most of
the tax burden.
Elastic supply (b):
−→ larger price changes,
consumers bear most of
the tax burden.
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Outline of Lecture
1. The Three Rules of Tax Incidence
2. Welfare losses of Consumption Taxes
3. Substitution Effects
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Deadweight Loss of Taxation
Source: Gruber (2005)
A tax leads to a welfare loss
(deadweight loss):
1. The price is higher than the
(efficient) market price.
2. Produced quantity decreases
compared to the (efficient)
market quantity.
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Tax Revenue
Source: Mankiw (2021)
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Deadweight Loss
Source: Mankiw (2021)
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Deadweight loss growth of Taxation
There is an overproportional
increase in the deadweight loss
with the tax rate.
▶ Small tax rates lead to
lower distortions.
▶ High tax rates lead to
larger distortions.
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Tax Distortions and Elasticities
Source: figure 5 Mankiw (2021)
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Pre-existing Distortions Matter – Positive Externalities
Source: Gruber (2005)
Taxes are particularly harmful if
there are positive externalities.
▶ There is already an
underproduction and
deadweight loss with positive
externalities.
▶ A tax increases the market
distortion and leads to even
more underproduction.
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Pre-existing Distortions Matter – Negative Externalities
Exception: Pigouvian Tax
There is an efficiency increase, when there
are negative externalities in the market.
▶ Pre-existing distortion gets corrected.
▶ The deadweightloss from the negative
externality dissapears after the tax.
▶ (Corrective) taxation can lead to a
welfare gain.
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Deadweight Loss and Tax Revenue
Source: figure 6 Mankiw (2021)
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Deadweight Loss and Tax Revenue
Source: figure 6 Mankiw (2021)
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Outline of Lecture
1. The Three Rules of Tax Incidence
2. Welfare losses of Consumption Taxes
3. Substitution Effects
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Excise Taxes and Substitution Effects
Example: An additional excise tax on beer, no additional tax on soda.
▶ Relative price of beer to soda increases.
▶ Individuals budget constraint shifts downwards: they can buy less beer with the
income that they have.
Source: Stiglitz and Rosengard (2015)
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Substitution Versus Income Effect
▶ Income Effect: How would consumption of beer have been reduced if we had taken away
income from the individual – to put him or her on the new, lower indifference curve – but,
at the same time, had not changed relative prices? (E to ˆE)
▶ Substitution Effect: Beer becomes relatively more expensive, leading to substitution
toward other goods. ( ˆE to E∗
)
Source: Stiglitz and Rosengard (2015)
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Readings for Next Lecture
Lecture 9: Taxation III
Stiglitz and Rosengard (2015)
▶ Chapter 19: Taxation of Savings (pp. 588-591)
▶ Chapter 19: Taxation of Labor Income (pp. 591-597)
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References I
Gruber, J. (2005). Public Finance and Public Policy, Worth Publishers.
Mankiw, N. G. (2021). Principles of economics, Cengage Learning.
Stiglitz, J. E. and Rosengard, J. K. (2015). Economics of the public sector (4th edition).
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