Commodity Taxes

In this video we cover taxes and tax revenue and subsidies on goods. We discuss commodity taxes, including who pays the tax and lost gains from trade, also called deadweight loss. We’ll take a look at the tax wedge and apply what we learn to the example of Social Security taxes.

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- [Tyler] Today we begin
the first of several talks

on taxes and subsidies.

We're not going to be talking
about income taxes

and income subsidies.

Those are typically topics
for macroeconomics.

Instead, we'll be talking
about taxes and subsidies on goods,

like a sales tax
or a subsidy for wheat.

These are also called
commodity taxes and subsidies.

So let's get going.

We're going to be emphasizing
three important ideas

about commodity taxation.

First, who pays the tax
does not depend

on who writes the check
to the government.

For example, suppose the government
is taxing apples.

The government could make
the buyer of apples

pay for each apple that they buy.

Or they could require the sellers
of the apples pay for each apple

that they sell.

What we're going to show is that,
from the point of view

of the buyers or sellers,
it actually doesn't matter

how the tax is placed.

The actual outcomes
are going to be identical.

Another way of putting this
is that the economic incidence

of the tax, who actually pays
the tax, does not depend

on the legal incidence,
who is in law required to write

the check to the government.

This will become a little bit
clearer as we go along.

Don't worry about it
if it's not clear yet.

The second key point,
who pays the tax

does depend on the relative
elasticities of demand and supply.

In fact, we can summarize
point one and point two by saying,

who pays the tax depends not
on the laws of congress

but rather on the laws
of supply and demand.

The third point
is that commodity taxation

raises revenue,
but it also takes away

some gains from trade, that is,
it creates deadweight loss.

We're going to be looking
at point one in this talk,

and then we'll move on
to point two, and point three

in later talks.

So, let's start with point one.

Let's begin our analysis
of commodity taxation

by assuming the suppliers
are the one who have to send

the check to the government.

That is, the legal incidence
of the tax falls on the suppliers.

What does a tax
on the suppliers do?

We can think about a tax
on suppliers

as increasing their costs.

This is going to shift
the supply curve up

by the amount of the tax,
so the supply curve

shifts up like this.

Another way of thinking
about this, is to remember

that the supply curve tells us
the minimum amount

which suppliers require to offer
a given quantity

in the marketplace.

The tax, that is going to increase
the minimum amount that suppliers

are requiring to offer
that quantity in the marketplace.

It shifts up that minimum amount
required by just the amount

of the tax.

With the new supply curve
we find the new equilibrium.

The market equilibrium
moves from point A to point B.

What we see is that of course,
the quantity which is exchanged

goes down, in addition,
the price paid

by the buyers goes up.

How much do the suppliers get?

The suppliers collect this amount,
the price paid by the buyers,

but now they have to give
a certain amount of that,

the tax to the government.

The suppliers end up receiving
this amount after tax, right here.

In other words, what the tax does,
it means that the buyers

pay more than before,
and the sellers receive

less than before.

Without any tax,
the price the buyers pay

is the same as the price
the supplier receives.

With the tax,
the buyers pay a certain price,

but the sellers get less than that.

They get whatever the buyers pay
minus of course, the tax.

That's the situation
when the suppliers pay the tax,

or the suppliers have to send
the check to the government.

Let's now look at what happens
when it's the buyers

who must send the check
to the government.

Now, we look at the situation
when the legal incidence

is on the buyers.

We begin just as before
with the equilibrium with no taxes.

No taxes on sellers or buyers.

Again, that equilibrium
is at point A.

I've also included
this supply curve here.

This is the supply curve
when the tax is on the suppliers.

It's the supply curve
from the previous problem.

It's not relevant for this problem.

I've included it rather
to remind us of where

the equilibrium
on the previous problem was.

You can think of this
as a kind of ghost supply curve.

It's a supply curve
from the previous problem

coming back to haunt us.

So what's the effect
of a tax on the demanders?

Think about it this way.

Suppose the most you were willing
to pay for an apple is $1.

Again, most you're willing to pay
for that apple, a dollar, no more.

Now, suppose you learned
that the government has instituted

a new tax.

For every apple you buy,
you must now pay 25 cents

to the government.

Now, how much
are you willing to pay

to suppliers for that apple?

You're only willing to pay
the maximum amount

that you're going to be willing
to pay suppliers

is now 75 cents.

The maximum amount
that apple was worth to you

is a dollar.

If you know you're going
to be taxed 25 cents

if you buy that apple,

then the most you're going
to be willing to pay the supplier

is 75 cents, because 75 cents
plus the 25 cent tax

to the government, that's $1.

That's the most you're willing
to pay to get the apple.

In other words, what a tax
on demanders does

is it reduces
their willingness to pay,

and that means
the demand curve shifts.

Which way? The demand curve shifts
down by the amount of the tax.

So let's shift.

The tax is exactly
the same amount that it was before.

Let's shift the demand curve
down by the amount of the tax.

We find now
that the new equilibrium

is at point B.

Notice first of all,
that the quantity has declined.

The quantity exchange has declined
by exactly the same amount

as before in the previous problem.

What about the price
received by the sellers?

The sellers now receive this price.

Lo and behold,
that's exactly the same price

as it was before.

How about the price
paid by the buyers?

The buyers now pay
what they paid to the suppliers,

plus they must pay the tax
to the government.

This distance is the tax.

Lo and behold, the price after tax
paid by the buyers

is once again exactly
what it was when the tax

was on the suppliers.

When the tax is on the buyers,
the buyers pay more than before.

The sellers receive less
than before

by exactly the same amounts.

The quantity declines
by the same amount, too.

The net price,
or the total price paid

by the buyers is the same.

The total price received
by the sellers is the same.

Now that you know the idea,
I'm going to show you a simpler way

of demonstrating this.

What we just showed
is that it doesn't matter

whether the suppliers
must write the check

to the government, or the demanders
must write the check

to the government
in order to pay the tax.

In other words,
we can analyze the tax

by shifting the supply curve up,
or by shifting

the demand curve down.

As long as we analyze
the same size tax,

we're going to get
equivalent outcomes.

It's going to come out the same
whichever choice of tax we make.

There's actually a simpler way
of thinking about this.

What we can think
about such a tax is doing,

is driving a wedge
between what the buyer is paying

and what the sellers receive.

When there's no tax,
what the buyers pay

is what the sellers receive,
but when there's a tax,

the buyers pay more
than what the sellers receive.

The difference
is what the government gets.

The difference
is the amount of the tax.

So let's think about this
as a tax wedge.

Let's say this tax wedge,
this side is, let's say a dollar.

Another way of analyzing
the tax is to drive this wedge

into the diagram
until the top of the wedge

hits the demand curve,
and the bottom of the wedge

just touches the supply curve.

Let's take a look.

I'm going to drive the wedge in.

What this tells us
is that the price the buyer pays

will be here, point B.

The price the suppliers receive
will be point D.

The difference is the tax.

For instance, if the buyers
end up paying $2.65,

then the sellers must receive $1.65
if the tax is a dollar.

Similarly, if the suppliers receive
a $1.65 and the tax is a dollar,

the buyers must be paying $2.65.

With this wedge, we could read
off the diagram

the price the buyer pays,
the price the seller receives,

and the quantity exchanged.

We don't even have
to shift any curves.

We just drive the wedge
into this diagram.

Let's do an application.

In the United States,

under the Federal Insurance
Contributions Act -- FICA --

12.4% of earned income
up to an annual limit

must be paid into social security,
and 2.9%, an additional 2.9%

must be paid into Medicare.

Half of this amount comes directly
from the employee.

You can see it
on your own paychecks.

This is the FICA tax,
and half the amount comes

from the employer.

The question is, does the fact
that it's a 50/50 split,

does this make a difference?

Does this mean for example,
that since the employer

is paying half that this is necessarily
a good deal for the employee?

No, it doesn't mean that.

What we now know
is that we could have 100%

of this tax paid by the employee,
or we could have 100%

of this tax paid by the employer.

This wouldn't make a difference,
not to wages, not to prices,

not to anything.

It would change
the legal incidence of the tax,

but it would not change
the final economic incidence.

I haven't said here
who actually pays the tax.

That's what we're going
to be talking about

in the next lecture.

What I've said here
is that it doesn't matter

who pays the tax
from a legal point-of-view

of who is obliged
to deliver that money.

So the legal incidence again,
does not have a bearing

on the economic incidence
of the tax.

What we're going to talk
about in the next lecture

is what does determine
the economic incidence of a tax.

It turns out to be elasticities
of supply and demand,

and that's what we'll take up
in the next lecture.

Thanks again for listening.

- [Narrator] If you want
to test yourself,

click "Practice Questions."

Or if you're ready to move on,
just click "Next Video."

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