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Econ 230A: Public Economics Lecture: Tax Incidence 1 Hilary Hoynes UC Davis, Winter 2013 1These lecture notes are partially based on lectures developed by Raj Chetty and Day Manoli. Many thanks to them for their generosity. Hilary Hoynes () Incidence UCDavis,Winter2013 1/61 Outline of Lecture 1 What is tax incidence? 2 Partial Equilibrium Incidence I Theory: Kotliko¤ and Summers, Handbook of Public Finance, Vol 2 I Empirical Applications: Doyle and Samphantharak (2008), Hastings and Washington 3 General Equilibrium Incidence – WILL NOT COVER 4 Capitalization & Asset Market Approach I Empirical Application: Linden and Rocko¤ (2008) 5 Mandated Bene…ts I Theory: Summers (1989) I Empirical Application: Gruber (1994) Hilary Hoynes () Incidence UCDavis,Winter2013 2/61 1. What is tax incidence? Tax incidence is the study of the e¤ects of tax policies on prices and the distribution of utilities/welfare. What happens to market prices when a tax is introduced or changed? Examples: I what happens when impose $1 per pack tax on cigarettes? Introduce an earnings subsidy (EITC)? provide a subsidy for food (food stamps)? I e¤ect on price –> distributional e¤ects on smokers, pro…ts of producers, shareholders, farmers,... This is positive analysis: typically the …rst step in policy evaluation; it is an input to later thinking about what policy maximizes social welfare. Empirical analysis is a big part of this literature because theory is itself largely inconclusive about magnitudes, although informative about signs and comparative statics. Hilary Hoynes () Incidence UCDavis,Winter2013 3/61 1. What is tax incidence? (cont) Tax incidence is not an accounting exercise but an analytical characterization of changes in economic equilibria when taxes are changed. Key point: Taxes can be shifted: taxes a¤ect directly the prices of goods, which a¤ect quantities because of behavioral responses, which a¤ect indirectly the price of other goods. If prices are constant economic incidence would be the same as legislative incidence. Knowing incidence is incredibly imporant for policy analysis. Hilary Hoynes () Incidence UCDavis,Winter2013 4/61 1. What is tax incidence? (cont) Ideally, we want to know the e¤ect of a tax change on utility levels of all agents in the economy. Realistically, we usually look at impacts on prices or income, rather than utility Useful simpli…cation is to aggregate economic agents into a few groups. 1 gas tax: producers vs consumers 2 EITC: suppliers vs demanders of labor, recipients vs nonrecipients 3 income tax: rich vs poor 4 property tax: region or country 5 social security: across generations Hilary Hoynes () Incidence UCDavis,Winter2013 5/61 2. Theory: Partial Equilibrium Incidence Key reference: Kotliko¤ & Summers (Hbk, Vol 2, 1987) Partial Equilibrium Model: Simple model goes a long way to showing main results. Two goods: x and y I Government levies an excise tax on good x F DEF: excise taxes are levied on a quantity (gallon, pack, ton, ...). Typically …xed in nominal terms (therefore subject to declines in real terms) F DEF: ad-valorem taxes are a fraction of prices (e.g. sales tax), marked automatically to in‡ation. I Let p denote the pretax price of x and q = p + t denote the tax inclusive price of x.(statutory incidence is on demander) I Good y, the numeraire, is untaxed. Hilary Hoynes () Incidence UCDavis,Winter2013 6/61 2. Theory: Partial Equilibrium Incidence Consumer has wealth Z and has utility u(x, y). Price-taking …rms use c(S) units of the numeraire y to produce S units of x (Cost function is c(S) and is expressed in units of the numeraire). I The marginal cost of production is weakly increasing: c0(S) > 0 and c (S) 0. 00 I The representative …rm’spro…t at pretax price p and level of supply S is pS c(S). I Assuming that …rms optimize perfectly, the supply function for good x is implicitly de…ned by the marginal condition p = c0(S(p)). (price=marginal cost) Hilary Hoynes () Incidence UCDavis,Winter2013 7/61 2. Theory: Partial Equilibrium Incidence Equilibrium condition: Q = S(p) = D(p + t) de…nes an equation p(t). dp We want to characterize dt – e¤ect of a tax increase on price, which determines who bears e¤ective burden of tax. dp Fully di¤erentiating equilibrium condition wrt t and solving for dt gives D dp ∂ = ∂p dt ( ∂S ∂D ) ∂p ∂p Hilary Hoynes () Incidence UCDavis,Winter2013 8/61 2. Theory: Partial Equilibrium Incidence Converting partial equalibrium result to elasticities (handy since independent of scaling) Elasticity: percentage change in quantity when price changes by one percent ∂D q I εD = ∂p D (p) denotes the price elasticity of demand. F (consumer faces q = p + t) ∂S p I εS = ∂p S (p) denotes the price elasticity of supply. dp ε = D dt (εS εD ) Note: 1 < dp/dt < 0 and dq = 1 + dp dt dt Hilary Hoynes () Incidence UCDavis,Winter2013 9/61 2. Theory: Partial Equilibrium Incidence Examples I Figure 1: Tax Levied on Producers (Gruber) Hilary Hoynes () Incidence UC Davis,Winter2013 10/61 2. Theory: Partial Equilibrium Incidence Examples I Figure 2: Tax Levied on Consumers ( Gruber) Hilary Hoynes () Incidence UC Davis,Winter2013 11/61 I 2. Theory: Partial Equilibrium Incidence dp ε = D dt (εS εD ) When do consumers bear the entire burden of the tax? I εD = 0 [inelastic demand] F example: short run demand for gas (need to drive to work) I εS = ∞ [perfectly elastic supply] F example: perfectly competitive industry When do producers bear the entire burden of the tax? I εS = 0 [inelastic supply] F example: …xed quantity supplied (housing) I ε = ∞ [perfectly elastic demand] D F example: there is a close substitute, and demand shifts to this substitute if price changes. Hilary Hoynes () Incidence UC Davis,Winter2013 12/61 2. Theory: Partial Equilibrium Incidence Examples (from Gruber) Hilary Hoynes () Incidence UC Davis,Winter2013 13/61 2. Theory: Partial Equilibrium Incidence key intuitions: 1 statutory incidence not equal to economic incidence 2 equilibrium is independent of who nominally pays the tax 3 more inelastic factor bears more of the tax These are robust conclusions that hold with more complicated models Extensions to partial equilibrium incidence: I Standard analysis assumes prices and taxes a¤ect demand in the same dx dx way: dt = dp . Chetty, Looney & Kroft (AER 2008) generalize theory to allow for salience e¤ects. We will talk about this paper later. I Market rigidities: Suppose there is a minimum or maximum price: then former analysis may not be correct. F Example: minimum wage. Social security taxes 7.5% on employer and 7.5% on employee. In principle the share of each should not matter as long as total is constant but minimum wage is computed on net wage (gross wage - employer tax = net wage + employee tax). Hilary Hoynes () Incidence UC Davis,Winter2013 14/61 2. Theory: Partial Equilibrium Incidence Extensions to partial equilibrium incidence (continued): I Imperfect competition such as monopoly (Salanie book). Possible to get an increase in after-tax price bigger than the level of the tax. Ad valorem and excise taxation are no longer equivalent. I Ignores e¤ects on other markets: F Example: Suppose tax on cigarettes increases, if people substitute cigarettes for cigars then price of cigars increases and part of the burden is shifted to the cigar market and cigarette demand curves will move. F Revenue e¤ects on other markets: tax increases, I am poorer, I have less to spend on other markets. F For small, narrow markets such as cigarettes, partial eq. analysis is a reasonable approximation (although e¤ects on substitutes could be important). Hilary Hoynes () Incidence UC Davis,Winter2013 15/61 3. Empirical Applications Typical empirical evidence on incidence: I State panel data I Identi…cation is variation across states over time in taxes I Challenge is whether tax changes are endogenous (do states make changes in response to current conditions?). Usual issue of validity of control group, common trends assumption, etc. Hilary Hoynes () Incidence UC Davis,Winter2013 16/61 3. Empirical Applications: Gas Tax (Doyle and Samphantharak JPubE 2008) Question: who bears the burden of the gas tax? Setting: Gas prices spike above $2.00 in 2000, near election, political desire to provide tax relief Led to repeal and subsequent reinstatement of SALES tax in Indiana (and Illinois) What I like about the application: I Salient tax, setting where there is attention to prices and govt intervention I Fall and Rise in prices (assymmetry? bounds possible bias) I Govenor could act alone so policy changed quickly Note: This is the SALES tax that is changed not the EXCISE tax (of which there is a federal and state). Not all states even tax gasoline in the sales tax. Hilary Hoynes () Incidence UC Davis,Winter2013 17/61 3. Empirical Applications: Gas Tax (Doyle and Samphantharak JPubE 2008) . What happened to taxes: I Indiana (IN) suspends 5% sales tax on gas starting July 1, reinstates on Oct 30 F extended on August 22 to September 15 F extended on September 13 to September 30 F extended September 28 to October 29 I Illinois (IL) suspends 5% sales tax on gas starting July 1, reinstates on Dec 31 reforms known to be temporary sales tax does not apply to certain excise taxes I sales tax applies to roughly 90% of the posted price in IL I sales tax applies to roughly 80% of the posted price in IN full shifting therefore implies 4.5% change in price in IL & 4% change in prices in IN Hilary Hoynes () Incidence UC Davis,Winter2013 18/61 3. Empirical Applications: Gas Tax (Doyle and Samphantharak JPubE 2008) Empirical approach in paper: DD, compare treated states with neighboring states (MI, OH, MO, IA, WI) I Flexible event time model; looking for sharp discontinuity I start with graphical evidence (unconditional, local linear regression) I next consider regression equation (controls for area characteristics, brand FE) s = station, b = brand, t = time ln(Retail Pricesbt ) = γ0 + γ1(IL or IN) + γ2(Post Reform) +γ [(IL or IN) (Post Reform)] 3 γ4 ln(Wholesale Price) + γ5Xs + δb + εsbt γ3 γ3 .04 ( .045 for IL) measures incidence Hilary Hoynes () Incidence UC Davis,Winter2013 19/61 3.
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