Introducing Taxes and Tax Incidence - Online Tutor, Practice Problems & Exam Prep

Taxes are essential for funding public services like education and safety. They can be imposed on buyers or sellers, affecting market equilibrium. A per unit tax shifts the demand or supply curve leftward, leading to higher prices for consumers and lower receipts for sellers. The tax burden is shared between buyers and sellers, determined by tax incidence. For example, with a $2 tax, consumers may pay $1.10, while producers bear $0.90. This distribution reflects the shapes of the demand and supply curves, illustrating that the tax's impact remains consistent regardless of who pays it.

Taxes and Tax Incidence

Hey guys, so I promised you we were going to talk about taxes in this course, and the time is finally upon us. Let's check it out. Alright, so first off, why are there taxes at all, right? Why are there taxes? It's for the government to provide public services, right? The government collects taxes so that they can provide public services like education, right? Public education, fire, police, all these services, they need money to provide them, and that comes from taxes, right? We're going to see in this chapter that taxes will either be imposed on the buyer or the seller, right? Someone's going to have to pay the tax, and one note about the taxes we're going to talk about is that we're going to be talking about per unit taxes, right? So this is a tax for each unit that is exchanged. So if the buyer is going to be charged, let's say a $1 tax per unit, that means if you bought one of these, you'd pay the price of the unit and you'd pay an additional $1 in tax. If you were to buy 2, you'd pay the price of the unit twice, but you pay $2 in tax. Right? 1 for each unit, so it's a per unit tax, okay? So let's talk about what the tax is going to do to the curves.

So when we see the tax imposed on a buyer or a seller, it's going to shift that curve by the amount of the tax, but do you think it's going to shift the curve to the left or to the right? So the idea here is it's going to shift to the left, right? When we talked about shifting left or right, we were talking about it being a good thing or a bad thing, right? This sounds like a bad thing. It's higher prices, right? It's going to shift the curve to the left and it's going to shift it by the amount of the tax, okay? We're going to see this in a second once we get down to these graphs. I was very particular in setting these up so that you could see that we're shifting by the amount of the tax.

Okay, so now for the first time, we're actually going to see a difference in the prices where the price that the consumer pays is going to be different from the amount the supplier receives, right? And that's because of the tax. So if the consumer is the one paying the tax, they're going to pay the amount of the good plus the amount of the tax, right? And the supplier is only going to receive the amount of the good without the tax. So there's going to be a difference in the amounts that each one pays or receives. So for the buyer, we're going to use this term p_b, the price to the buyer, and to the seller, we're going to use p_s, for the price to the seller, okay? And so when we talk about price, let's talk about the quantity too. So this tax when the tax is put into the market, it's going to affect our equilibrium that we're not at the equilibrium we wanted to be, right? It's going to cause an inefficiency in the market, and it's going to force us to exchange a lower quantity. A tax always makes the quantity exchanged less than the equilibrium. If the tax was imposed on the buyers, it doesn't necessarily mean that they're going to bear the full burden of the tax, right? The tax burden actually gets split between the buyer and the seller once the market adjusts. So let's go ahead and see that on the graph and we'll start here with taxes on the buyer.

Okay, so what we have is a situation, right? We've got our price axis and our quantity axis here, and in blue, we have our original situation. We have our supply curve here and our original demand curve which I'll call D1 and S1. Okay? So in our original situation, we were at this market equilibrium right here right of $6 and at that market equilibrium of $6, we were trading at this quantity Q star, right? This equilibrium quantity and the government steps in and says, alright, for every unit you buy of this item, you're going to have to pay a $2 tax. So the tax was put onto the buyers here and just like we said above when you get the party that gets taxed, their curve is going to shift to the left by the amount of the tax and that's exactly what we see here.

Effectively, the tax was $2 right? I'm going to write that I don't know where I'll write it. I'll write it right here up top. Tax equals $2 and over here it's going to be $2 as well once we get to the seller, so I'm just going to write that in. The tax is $2 and look what's happened to our demand curve. So our demand curve shifted to the left, right? We've got our new demand curve here to the left and it's shifted by $2 right? If we look on the price axis, we've got a $2 shift. I did it very specifically because it's $2. All of these are going up by 1, 2, 3, 4, right, and that is a $2 shift. We've got 2 squares in there, right? And that's important because I'm trying to be very specific in our ranges here because I'm making a point eventually. So let's go ahead and see what happens.

So in this case, right, the tax was on the buyer, we shifted demand to the left. I'll write that in this box. The demand went to the left by that $2 tax. So what happens once the demand shifts? We shifted it to the left and we have this new demand curve D2, right? Our second demand curve afterward and sometimes actually you'll see this called D plus tax or if it's on the supplier S plus tax, that happens sometimes, there's just a few different ways to name it. Alright, so we're at this new demand curve, right? So what is our new equilibrium here? So the new demand curve crosses the supply curve right here, right? That's going to be the new equilibrium price of $5.10 and notice we have a lower equilibrium quantity here, right? The quantity.onPause() is lower after the tax. I'll put QT.onPause(). QT quantity with the tax, right? It's this lower amount. Okay? So at this price of $5.10, that's the price that's going to be exchanged and that's the amount that we're going to see the sellers receive. The sellers are going to receive this PS of $5.10, but remember the buyers had to pay a $2 tax, right? And that's exactly what we're seeing here. So the sellers are going to receive that $5.10, and then when the buyer gets a unit, they're going to on top of that $5.10 have to pay $2. So you're going to see this right here, right? The price the buyers pay is actually the $7.10, right? And you'll notice that in this case, it's not like the price went up by $2 to the consumer, right?

Tax Incidence

Alright, let's try this example. The following graph depicts the market for a bag of magic beans. If the government imposes a tax of 1 cow on buyers of magic beans, what is the tax incidence on producers of magic beans? Alright, so let's go ahead and look at our graph here real quick. So we've got our price, which is in cows and our quantity over here, right? And we've got a supply and demand curve, and then we're going to have a shift in the demand curve because there's a tax on the buyers, right? When the tax is on the buyers, the demand curve is gonna shift and this one's our original demand curve because that's where we have this one price, right? Where we have this cross and this equilibrium going on right here. So right there was our original equilibrium at 2.5, right? So man, this must be some sort of dystopian future Jack and the Beanstalk where first of all, there's been a lot of inflation, right? Jack was able to get his bag of magic beans for just one cow and now we're talking about an equilibrium of 2.5 cows, so we're dealing in half cows. Man, this society's gotten pretty weird. So anyway, at this 2.5 price, that was our original q star, right. So let's go ahead and see what happens after this tax is imposed. So the tax is on the buyer and we're gonna shift the demand curve just like they have here and this is gonna be d₂, right. That was d₁, this is d₂ or d with the tax, right. So it's asking us what is the tax incidence on producers, right? The tax incidence is the share of the tax that that party is gonna pay. In this case, the producers. So what is the share of the tax to the producers? We know that the total tax was 1, right? There was 1 cow that was being the additional tax here. So it's pretty easy to find it and it's only this area here is representing the tax, right? Between the 1.9 and the 2.9. So how do we gauge what is the amount paid by producers? Well, we know that up here, this 2.9, that's the price the buyers are going to pay, right? They're going to pay this price, P_B and the sellers are gonna receive 1.9, right? Because of that 1 cow tax. So, if the original equilibrium was at 2.5, right? So sellers were originally receiving 2.5 cows per bag, now they're only receiving 1.9 cows per bag. So what's the difference? 2.5 cows they were originally receiving minus 1.9, they're paying 0.6 cows of this tax. Right? They're taking 0.6 out of the one, and we can turn this into a percentage pretty quick, right? 0.6 divided by the total tax, which was 1 and that's gonna give us 0.6, right? So that as a decimal is 60%. So 60% of the cow tax is being paid by producers in this case and you can see the other 40%, right the 2.9 minus the 2.5, that's being paid by the consumers in this market. Alright, the tax incidence on producers is gonna be 60% or 0.6 cows. Alright, let's go ahead to the next video.

If a tax is levied on the sellers of a product, the demand curve:

• A. Shifts to the left in an amount equal to the tax
• B. Shifts to the right in an amount equal to the tax
• C. Does not change
• D. Is inelastic

A tax was levied upon buyers of a good. What is the amount sellers receive after the tax is imposed? 

• A. 19
• B. 25
• C. 29
• D. None of the above

Here’s what students ask on this topic:

Why are taxes necessary for the government?

Taxes are essential for the government to fund public services such as education, fire and police departments, and infrastructure. Without taxes, the government would lack the financial resources to provide these critical services that benefit society as a whole. Taxes ensure that the government can maintain and improve public goods and services, which are vital for the well-being and safety of the community.

How does a per unit tax affect the supply and demand curves?

A per unit tax shifts the supply or demand curve to the left by the amount of the tax. If the tax is imposed on buyers, the demand curve shifts leftward, indicating a decrease in quantity demanded at each price level. Conversely, if the tax is imposed on sellers, the supply curve shifts leftward, indicating a decrease in quantity supplied at each price level. This shift results in higher prices for consumers and lower receipts for sellers, disrupting the market equilibrium.

What is tax incidence and how is it determined?

Tax incidence refers to the distribution of the tax burden between buyers and sellers. It is determined by the relative elasticities of supply and demand. For example, if a $2 tax is imposed, consumers might pay $1.10 while producers bear $0.90. The more inelastic side of the market (less responsive to price changes) will bear a larger share of the tax burden. This distribution is calculated by comparing the changes in prices paid by consumers and received by producers before and after the tax.

Does it matter whether the tax is imposed on buyers or sellers?

No, it does not matter whether the tax is imposed on buyers or sellers. The final economic outcome remains the same. The market adjusts so that the tax burden is shared between buyers and sellers, regardless of who is initially taxed. The only difference is which curve (supply or demand) shifts. Ultimately, the prices paid by consumers and received by producers will reflect the tax incidence, leading to the same equilibrium quantity and price distribution.

How does a tax create market inefficiency?

A tax creates market inefficiency by causing a deadweight loss, which is the reduction in total surplus that occurs because the tax discourages mutually beneficial trades. The imposition of a tax leads to a lower equilibrium quantity than would be achieved in a tax-free market. This means fewer transactions occur, resulting in lost gains from trade for both consumers and producers. The market is no longer at its most efficient point, where supply equals demand without any external intervention.