Chapter 12:
Taxation and
Income Distribution
Econ 330: Public Finance
Dr. Reyadh Faras
Dr. Reyadh Faras
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Taxation and Income Distribution
Tax Incidence
 Statutory Incidence: who is legally responsible for
paying the tax.
 Economic Incidence: the change in the distribution of
private real income induced by a tax.
 Size Distribution of Income: how taxes affect the way
in which total income is distributed among people.
Dr. Reyadh Faras
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Sources and Uses Should be Considered
 For example, a sales tax not only reduces demand but
also reduces incomes received by factors of production.
 Both producers and consumers are affected, but the
overall incidence depends on how both sources and
uses of income are affected.
 In practice, economists ignore effects on sources
(inputs) when considering a tax on a commodity and
ignore uses (consumers) when considering a tax on an
input.
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Incidence Depends on How Prices are Determined
 Determining who bears the burden of the tax depends
on how the tax changes prices.
 An important determinant is time; because price
changes take time.
 In most cases, responses are larger in the long run
than the short run, implying that the tax incidence may
differ according to time.
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Incidence Depends on the Disposition of Tax Revenues
 Balanced Budget Incidence: Computes the combined
effects of levying taxes and government spending
financed by those taxes.
 In general, the distributional effect of a tax depends
on how the government spends the money.
 Tax revenues are usually not assigned for particular
expenditures.
 Differential tax incidence: Examines how incidence
differs when one tax is replaced with another, holding
the government budget constant.
 Because DTI looks at changes in taxes, a hypothetical
reference tax system is used in comparison between
different taxes.
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Lump Sum Tax: A tax which does not depend upon
individual’s behavior.
Absolute Tax Incidence: Examines the effects of a tax
when there is no change in either; other taxes or
government expenditure.
Measuring Progressiveness of Taxes
Average Tax Rate: the ratio of tax liability to income.
Proportional: average tax rate is constant regardless of
income level.
Progressive: average tax rate increases with income.
Regressive: average tax rate falls with income.
Marginal Tax Rate: the change in taxes with respect to
a change in income.
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Tax liabilities under a hypothetical tax system
Income
$ 2,000
Tax Liability Average Tax
Rate
Marginal
Tax Rate
$ -200
3,000
0
5,000
400
10,000
1,400
30,000
5,400
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First: the greater the increase in average tax rates as
income increases, the more progressive is the system.
Algebraically:
v = _________
Second: A tax system with higher elasticity of tax
revenues with respect to income is more progressive.
Algebraically:
v = _________
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Partial Equilibrium Models
They are models that look only at the market in which
the tax is imposed and ignore the ramifications in other
markets.
A. Unit Taxes on Commodities
A unit tax is a fixed amount per unit of a commodity
sold.
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Implications of the analysis of a unit tax
1. The incidence is independent of whether it is levied
on consumers or producers.
2. The incidence depends on the elasticities of supply
and demand.
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B. Ad Valorem Taxes
 An ad valorem tax is a tax with a rate given as a
proportion of the price.
 The analysis similar to that of the unit tax.
 The only difference is that the demand curve does
not shift by the same absolute amount for each
quantity, instead it shifts downward proportionally.
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C. Taxes on Factors
1. The Payroll Tax
 These are taxes imposed on workers as percentage of
their incomes.
 The incidence is determined by the difference
between what employers pay and what employees
receive.
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2) Capital Taxation
 These are taxes imposed on owners of capital.
D. Profits Taxes
 These are taxes imposed on firms profits.
 In a perfectly competitive market, firm’s output is
determined by the intersection of its marginal cost and
marginal revenues schedules.
 A proportional profit tax changes neither marginal
cost nor marginal revenue.
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 Therefore, no firm has the incentive to change
its output decision, which means that the price
remains constant; consumers are not worse off.
 The tax is completely absorbed by the firm.
 Profit taxes seem attractive because they distort
no economic decisions.
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