The Benefits of Taxation

The benefits of taxation are the goods and services

that government provides.

Burden of Tax

Provides a stable set of institutions and rules

Promotes effective and workable competition
Corrects for externalities
Creates an environment that fosters stability and growth
Provides public goods
Adjusts for undesirable market results

7-3

Two Principles of Taxation

Who Bears the Burden of a Tax?

The benefits principle the individuals who

receive the benefit of the good or service
should pay the tax necessary to supply the
good.
The ability-to-pay principle individuals who
are most able to bear the burden of the tax
should pay.

The supply and demand framework gives the

answer to this question.

Burden Depends on Relative

Elasticity

The person who physically pays the tax is

not necessarily the person who bears the
burden of the tax.
The burden of the tax is rarely shared equally
since elasticities are rarely equal.

Burden Depends on Relative

Elasticity

The more inelastic ones relative supply and

demand, the larger the tax burden one will
bear.

Who Bears the

Burden of a Tax?

If demand is more inelastic than supply,

consumers will pay the higher share.
If supply is more inelastic than demand,
suppliers will pay the higher share.

Supplier Pays Tax

S1
Price of luxury boats

Burden Depends on Relative

Elasticity

$70,000
60,000
50,000
40,000
30,000
20,000
10,000

S0

Supplier pays

Demand
510
200

McGraw-Hill/Irwin

tax

Consumer pays

400

600 Quantity of luxury boats

2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Who Bears the

Burden of a Tax?

Who Bears the

Burden of a Tax?

Demand is inelastic
S1
S0

Demand
590

400

600 Quantity of luxury boats

tax S
0

60
50
40

510 600

Quantity of luxury boats

$70

S1

S0

60
50
40
590

D0

D1
510
400

600 Quantity of luxury boats

2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

of
t
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$70
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$70
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Quantity of luxury boats
Quantity
of
luxury
boats
w

Supplier pays the taxSupply shifts

500 600

Quantity of luxury boats

Consumer pays the taxDemand shifts

Price of luxury boats

S1

tax

Who Bears the Tax Burden?

Demand is inelastic
Larger consumer burden

Price of luxury boats

Price of luxury boats

$70

Supplier pays

McGraw-Hill/Irwin

Who Bears the Tax Burden?

Demand is elastic
Equal burden

S0
Consumer pays

200

2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin

$70,000
60,000
50,000
40,000
30,000
20,000
10,000

Price of luxury boats

200

tax

Price of luxury boats

Price of luxury boats

$70,000
Consumer pays
60,000
50,000
Supplier pays
40,000
30,000
20,000
10,000

Consumer Pays Tax

Who Pays Versus Who Bears the

Burden of a Tax

Tax Incidence and Current Policy

Debates

Social Security Taxes

Social Security Taxes

Both employer and employee contribute the

same percentage of before-tax wages to the
Social Security fund.

The fact that both the employer and

employee contribute the same percentage
does not mean they share the burden
equally.

The burden of a tax is independent of who

physically pays the tax.

The analysis of tax incidence is helpful when

discussing current policy debates.

Social Security Taxes

Sales Taxes

On average, labor supply tends to be less

elastic than labor demand, so the Social
Security tax burden is primarily on
employees.

Sales taxes are those paid by retailers on the

basis of their sales revenue.
Since sales taxes are broadly defined,
consumers find it hard to substitute.
Demand is inelastic so consumers bear the
greater burden of the tax.

Sales Taxes
As consumers increase purchases on the
internet where sales are not taxed, retail
stores will bear a greater burden of the sales
tax.