♪ [music] ♪ - [Tyler] In the last lecture, we showed that the legal incidence of a tax does not determine the economic incidence. In this lecture, we're going to talk about how the economic incidence of taxes actually is determined. Who bears the burden of a tax?
Here is the rule for the economic incidence of a tax. The more elastic side of the market will pay a smaller share of the tax, a smaller burden. Similarly, the less elastic side of the market or rather the more inelastic side of the market will pay a greater share of the tax.
So more elastic pays a smaller share, less elastic pays a greater share. I'm going to show you this in a couple of diagrams and then give you the intuition for why it's the case. Let's suppose we can't remember the rule.
Is it the more elastic side which bears the smaller share of the tax or the greater share of the tax? Say we can't quite remember. Well, no problem.
Let's just draw the diagram and read it off as it happens. For instance, let's draw a diagram which has a pretty elastic demand curve and relatively speaking a pretty inelastic supply curve. Here's the price when there's no tax.
Now let's look at what happens when there is a tax and we'll use our wedge method. Here's the tax and the height of the wedge gives us the amount of the tax. What do we do?
We drive this wedge into the diagram until the top of it hits the demand curve and the bottom of it hits the supply curve and then we just read the answer off our diagram. Point B, this tells us the price paid by the buyer. Point D, this tells us the price received by the seller.
Let's compare. When there was no tax, the price paid by the buyer was at A, and with the tax the price to the buyer goes up a little bit to point B. The buyer isn't paying much of a higher price.
On the other hand the seller is receiving a lot less. In this case, when demand is more elastic than supply, the demanders pay a smaller share of the tax and the suppliers pay a larger share. Therefore we can just read off the diagram what happens when demand is more elastic than supply.
You don't have to remember the rule, you don't have to memorize it because I'm going to give you some intuition to make it easy in just a moment. You simply have to draw the diagram and be able to read the answer off the curves. Let's look at another case.
In this case, we've drawn a supply curve which is very inelastic and a demand curve which is less elastic than the supply curve. Once again we're going to take our tax wedge, we're going to push it into the diagram and what happens? You can see it right here.
We just have to read it off the diagram. Now we see that compared to when there was no tax, the price to the buyer has gone up a lot and the price to the sellers has gone down by just a little bit. When the supply is more elastic than demand, buyers pay the greater share of the tax, that is the price to the buyer goes up more than the price to the sellers goes down.
The buyers pay more of the tax when the supply curve is more elastic. Let's give some intuition. You can always get the right answer by drawing the curves.
And let's consider the intuition for why that's the case. So here's the intuition for remembering the rule. Think about elasticity as a kind of escape.
The side of the market which is the more elastic can escape the tax more easily. Why does that makes sense? Remember what elastic demand means.
It means that demanders have good substitutes for the taxed good and so they can escape the tax. When the tax is high, the demanders are going to say, "We're just going to go buy the substitutes. We have plenty of good substitutes.
" On the other hand, think about what it means when the demand is inelastic. It means that there are no good substitutes so it's hard to escape the tax. What about the supply side, elastic supply?
Well, that means the resources which are used to produce the taxed good, they can easily be moved to other industries. The resources can move around easily. If you try to tax the industry a lot then the land, the capital, the workers in that industry which were used to produce the good, they're just going to flow to other industries and so the suppliers can relatively easily escape the tax.
On the other hand, if supply is inelastic that means the resources used to produce this good, they really can only be used to produce this good. They're fixed, they're hard to move around, and those factors are not that useful for producing other goods, so that makes it difficult for the suppliers when the supply curve is inelastic. That means it's difficult for the suppliers to escape the tax.
What if the demanders and the suppliers are both pretty elastic? Well, here's the thing. Somebody has to pay the tax, both sides can't escape the tax at least if the good is going to be bought and sold, therefore the burden is determined by the relative elasticities.
It's about which side has it easier to escape the tax and that side will pay less of the tax. The side which is less elastic, they're going to pay more of the tax because that side finds it harder to escape the tax. So let's do an application, say social security taxes.
Last time we showed that the legal incidence of social security taxes has no bearing on the economic incidence, but we didn't say what the economic incidence actually is. So let's do that now. We're going to have the price of labor up here, the wage, and the quantity of labor down here.
The whole question now boils down to is the demand for labor, more elastic than the supply of labor or vice versa? Think about the demanders of labor, businesses, what substitutes for labor do they have? If the price of labor goes up, what can those businesses do?
What about the supply of labor, the workers? If their wage goes down, what can they do? If you think about it, I think you'll see that for most workers, especially full time workers, they don't really have a lot of good substitutes for work.
Most workers need some kind of job. Even if their wage goes down, they're going to continue to work because they need to pay the bills. On the other hand, the demanders of labor if the wage were to go up, they could substitute capital for labor, they could move their investments to other countries.
They have quite a few good substitutes. So if that's actually how it works, we should probably draw the diagram like this with a fairly inelastic supply of labor and a fairly elastic demand for labor. Economists have done studies of this and on average this is what they find.
So now think about your FICA taxes, that's a tax on labor. What's the effect of that? Well, it's going to look something like this.
Notice that the wage paid by buyers of labor, that's the wage paid by the firms -- that goes up only a little bit. On the other hand, the wage received by the suppliers of labor, that is the wage which the workers end up with, that goes down by a lot. And this makes perfect sense when we have a very inelastic supply of labor.
The laborers can't escape the tax and, therefore, they end up bearing most of the burden of the tax. This doesn't mean, by the way, that we shouldn't have social security taxes. It may in fact be a good way of forcing people to save for their own future, but this does mean it is not a free lunch for the workers.
The workers' wages will drop because of the tax. If we didn't have the social security tax, wages for most workers would in fact be higher. Here's one more application, health insurance mandates.
Suppose that the government requires employers to provide health insurance to their workers as is now the case for many employers under the Affordable Care Act. Who's going to pay for this? Who will end up paying for this?
Is it primarily the employers or primarily the workers? It's really just the same analysis as we had before. A health insurance mandate is quite similar to a tax.
A health insurance mandate simply means that the employers have to pay a higher wage, but that's just, then, the same as a tax. What we just saw is that if labor supply is less elastic than labor demand, which in many cases makes sense, then in that case most of the mandate will actually be paid for by the workers. Real wages will fall.
Again this doesn't necessarily mean that the mandate is a bad idea but it does mean it's not a free lunch for the workers. The workers end up paying for their health care through the medium of lower wages. Taxes have a couple of other effects including the raising of revenue and also creating some dead weight loss.
Those are what we're going to look at in the next lecture. - [Narrator] If you want to test yourself, click Practice questions. Or if you're ready to move on, just click Next Video.
