Econ 230A: Public Economics

1 Econ 230A: Public EconomicsLecture: Tax Incidence1 Hilary HoynesUC Davis, Winter 20131 These lecture notes are partially based on lectures developed by Raj Chetty and DayManoli. Many thanks to them for their Hoynes ()IncidenceUC Davis, Winter 20131 / 61 Outline of Lecture1 What is tax incidence ?2 Partial Equilibrium IncidenceITheory: Kotliko and Summers, Handbook of Public Finance, Vol 2 IEmpirical Applications: Doyle and Samphantharak (2008), Hastingsand Washington3 General Equilibrium incidence WILL NOT COVER4 Capitalization & Asset Market ApproachIEmpirical Application: Linden and Rocko (2008)5 Mandated Bene tsITheory: Summers (1989)IEmpirical Application: Gruber (1994)Hilary Hoynes ()IncidenceUC Davis, Winter 20132 / 611. What is tax incidence ?Tax incidence is the study of the e ects of tax policies on prices andthe distribution of happens to market prices when a tax is introduced or changed?

2 Examples:Iwhat happens when impose $1 per pack tax on cigarettes? Introducean earnings subsidy (EITC)? provide a subsidy for food (food stamps)?Ie ect on price >distributional e ects on smokers, pro ts ofproducers, shareholders, farmers,..This is positive analysis: typically the rst step in policy evaluation; itis an input to later thinking about what policy maximizes analysis is a big part of this literature because theory isitself largely inconclusive about magnitudes, although informativeabout signs and comparative Hoynes ()IncidenceUC Davis, Winter 20133 / 611. What is tax incidence ? (cont)Tax incidence is not an accounting exercise but an analyticalcharacterization of changes in economic equilibria when taxes point: Taxes can be shifted: taxes a ect directly the prices ofgoods, which a ect quantities because of behavioral responses, whicha ect indirectly the price of other prices are constant economic incidence would be the same aslegislative incidence is incredibly imporant for policy Hoynes ()IncidenceUC Davis, Winter 20134 / 611.

3 What is tax incidence ? (cont)Ideally, we want to know the e ect of a tax change on utility levels ofall agents in the , we usually look at impacts on prices or income, ratherthan utilityUseful simpli cation is to aggregate economic agents into a tax: producers vs consumers2 EITC: suppliers vs demanders of labor, recipients vs nonrecipients3income tax: rich vs poor4property tax: region or country5social security: across generationsHilary Hoynes ()IncidenceUC Davis, Winter 20135 / 612. Theory: Partial Equilibrium IncidenceKey reference: Kotliko & Summers (Hbk, Vol 2, 1987)Partial Equilibrium Model:Simple model goes a long way to showing main goods:xandyIGovernment levies an excise tax on goodxFDEF: excise taxes are levied on a quantity (gallon, pack, ton, ..).Typically xed in nominal terms (therefore subject to declines in realterms)FDEF: ad-valorem taxes are a fraction of prices ( sales tax), markedautomatically to in the pretax price ofxandq=p+tdenote the taxinclusive price ofx.

4 (statutory incidence is on demander)IGoody, the numeraire, is Hoynes ()IncidenceUC Davis, Winter 20136 / 612. Theory: Partial Equilibrium IncidenceConsumer has wealthZand has utilityu(x,y).Price-taking rms usec(S)units of the numeraireyto produceSunits ofx(Cost function isc(S)and is expressed in units of thenumeraire).IThe marginal cost of production is weakly increasing:c0(S)>0 andc00(S) representative rm s pro t at pretax pricepand level of supplySispS c(S).IAssuming that rms optimize perfectly, the supply function for goodxis implicitly de ned by the marginal conditionp=c0(S(p)).(price=marginal cost)Hilary Hoynes ()IncidenceUC Davis, Winter 20137 / 612. Theory: Partial Equilibrium IncidenceEquilibrium condition:Q=S(p)=D(p+t)de nes an equationp(t).We want to characterizedpdt e ect of a tax increase on price, whichdetermines who bears e ective burden of di erentiating equilibrium condition wrttand solving fordpdtgivesdpdt= D p( S p D p)Hilary Hoynes ()IncidenceUC Davis, Winter 20138 / 612.

5 Theory: Partial Equilibrium IncidenceConverting partial equalibrium result to elasticities (handy sinceindependent of scaling)Elasticity: percentage change in quantity when price changes by onepercentI D= D pqD(p)denotes the price elasticity of (consumer facesq=p+t)I S= S ppS(p)denotes the price elasticity of D( S D)Note: 1<dp/dt<0 anddqdt=1+dpdtHilary Hoynes ()IncidenceUC Davis, Winter 20139 / 612. Theory: Partial Equilibrium IncidenceExamplesIFigure 1: Tax Levied on Producers (Gruber)Hilary Hoynes ()IncidenceUC Davis, Winter 201310 / 612. Theory: Partial Equilibrium IncidenceExamplesIFigure 2: Tax Levied on Consumers ( Gruber)IHilary Hoynes ()IncidenceUC Davis, Winter 201311 / 612. Theory: Partial Equilibrium Incidencedpdt= D( S D)When do consumers bear the entire burden of the tax?I D=0 [inelastic demand]Fexample: short run demand for gas (need to drive to work)I S= [perfectly elastic supply]Fexample: perfectly competitive industryWhen do producers bear the entire burden of the tax?

6 I S=0 [inelastic supply]Fexample: xed quantity supplied (housing)I D= [perfectly elastic demand]Fexample: there is a close substitute, and demand shifts to thissubstitute if price Hoynes ()IncidenceUC Davis, Winter 201312 / 612. Theory: Partial Equilibrium IncidenceExamples (from Gruber)Hilary Hoynes ()IncidenceUC Davis, Winter 201313 / 612. Theory: Partial Equilibrium Incidencekey intuitions:1statutory incidence not equal to economic incidence2equilibrium is independent of who nominally pays the tax3more inelastic factor bears more of the taxThese are robust conclusions that hold with more complicated modelsExtensions to partial equilibrium incidence :IStandard analysis assumes prices and taxes a ect demand in the sameway:dxdt=dxdp. Chetty, Looney & Kroft (AER 2008) generalize theoryto allow for salience e ects. We will talk about this paper rigidities: Suppose there is a minimum or maximum price: thenformer analysis may not be : minimum wage.

7 Social security taxes on employer on employee. In principle the share of each should not matter aslong as total is constant but minimum wage is computed on net wage(gross wage - employer tax = net wage + employee tax).Hilary Hoynes ()IncidenceUC Davis, Winter 201314 / 612. Theory: Partial Equilibrium IncidenceExtensions to partial equilibrium incidence (continued):IImperfect competition such as monopoly (Salanie book). Possible toget an increase in after-tax price bigger than the level of the tax. Advalorem and excise taxation are no longer e ects on other markets:FExample: Suppose tax on cigarettes increases, if people substitutecigarettes for cigars then price of cigars increases and part of the burdenis shifted to the cigar market and cigarette demand curves will e ects on other markets: tax increases, I am poorer, I haveless to spend on other small, narrow markets such as cigarettes, partial eq.

8 Analysis is areasonable approximation (although e ects on substitutes could beimportant).Hilary Hoynes ()IncidenceUC Davis, Winter 201315 / 613. Empirical ApplicationsTypical empirical evidence on incidence :IState panel dataIIdenti cation is variation across states over time in taxesIChallenge is whether tax changes are endogenous (do states makechanges in response to current conditions?). Usual issue of validity ofcontrol group, common trends assumption, Hoynes ()IncidenceUC Davis, Winter 201316 / 613. Empirical Applications: Gas Tax (Doyle andSamphantharak JPubE 2008)Question: who bears the burden of the gas tax?Setting: Gas prices spike above $ in 2000, near election, politicaldesire to provide tax reliefLed to repeal and subsequent reinstatement of SALES tax in Indiana(and Illinois)What I like about the application:ISalient tax, setting where there is attention to prices and govtinterventionIFall and Rise in prices (assymmetry?)

9 Bounds possible bias)IGovenor could act alone so policy changed quicklyNote: This is the SALES tax that is changed not the EXCISE tax (ofwhich there is a federal and state). Not all states even tax gasoline inthe sales Hoynes ()IncidenceUC Davis, Winter 201317 / 613. Empirical Applications: Gas Tax (Doyle andSamphantharak JPubE 2008).What happened to taxes:IIndiana (IN) suspends 5% sales tax on gas starting July 1, reinstates onOct 30 Fextended on August 22 to September 15 Fextended on September 13 to September 30 Fextended September 28 to October 29 IIllinois (IL) suspends 5% sales tax on gas starting July 1, reinstates onDec 31reforms known to be temporarysales tax does not apply to certain excise taxesIsales tax applies to roughly 90% of the posted price in ILIsales tax applies to roughly 80% of the posted price in INfull shifting therefore implies change in price in IL & 4%change in prices in INHilary Hoynes ()IncidenceUC Davis, Winter 201318 / 613.

10 Empirical Applications: Gas Tax (Doyle andSamphantharak JPubE 2008)Empirical approach in paper: DD, compare treated states withneighboring states (MI, OH, MO, IA, WI)IFlexible event time model; looking for sharp discontinuityIstart with graphical evidence (unconditional, local linear regression)Inext consider regression equation (controls for area characteristics,brand FE)s=station,b=brand,t=timeln(Retail Pricesbt)= 0+ 1(IL or IN)+ 2(Post Reform)+ 3[(IL or IN) (Post Reform)] 4ln(Wholesale Price)+ 5Xs+ b+ sbt ( IL) measures incidenceHilary Hoynes ()IncidenceUC Davis, Winter 201319 / 613. Empirical Applications: Gas Tax (Doyle andSamphantharak JPubE 2008)Unconditional estimates: Local linear regression of di erence (treatedstate - control state) in log priceHilary Hoynes ()IncidenceUC Davis, Winter 201320 / 613. Empirical Applications: Gas Tax (Doyle andSamphantharak JPubE 2008)A: July Tax RepealDependent Variable:(1)(2)(3)Illinois or ( )( )( )Post July ( )( )( )(IL or IN)*Post July ( )( )( ) of Dep.