Difficulty: Intermediate | Prerequisites: Supply and demand (Chapter 4), elasticity (Chapter 5), price controls (first half of this lecture).
Governments tax goods and labour to fund public projects such as roads, schools, and defence. This section of the course asks a deceptively simple question: when the government places a tax on a market, who ends up paying it? The answer, it turns out, has nothing to do with who the law says must write the cheque and everything to do with the relative elasticities of supply and demand. You need to be comfortable with shifting supply and demand curves and with the concept of elasticity before tackling this material.
A tax on a good creates a wedge between the price buyers pay and the price sellers receive, reducing the equilibrium quantity. Whether the law places the tax on buyers or sellers, the economic outcome (prices, quantities, and who bears the burden) is identical. The side of the market that is less elastic (less able to leave) bears the larger share of the tax.
Tax incidence
The division of the burden of a tax between buyers and sellers. In simple terms, it answers the question "who really pays?" regardless of who the law says must hand the money to the government.
Tax burden
The increased cost for buyers when buying the same good, and the reduced revenue for sellers when selling the same good, as a result of the tax.
Tax wedge
The gap between the price buyers pay (P_B) and the price sellers receive (P_S) after a tax is imposed. The size of the wedge equals the tax per unit.
Price paid by buyers (P_B)
The total amount buyers spend per unit after the tax, including any tax they must remit. Think of it as the full out-of-pocket cost to the buyer.
Price received by sellers (P_S)
The amount sellers keep per unit after the tax, net of any tax they must remit. Think of it as what lands in the seller's pocket.
Payroll tax
A tax on labour, typically split by law between employers and employees. The "price" in this market is the wage. In simple terms, it is the tax deducted from your pay cheque (employee share) plus the extra cost your employer pays on top of your salary (employer share).
Statutory incidence
Who the law says must send the tax payment to the government. This is distinct from economic incidence (who actually bears the burden), which depends on elasticity.
Economic incidence
Who actually bears the burden of the tax, determined by relative elasticities of supply and demand, not by the law.
Tags: tax on buyers, demand shift, pizza tax example, buyer tax burden
When a tax is levied on buyers, it shifts the demand curve downward by the amount of the tax.
Pizza example: a $1.50 per-slice tax on buyers.
Before the tax, equilibrium price is $10.00 and equilibrium quantity is 500 slices.
Buyers must now pay the market price plus $1.50 to the government. To induce buyers to demand the same quantity, the market price must fall by $1.50 to compensate. This shifts the demand curve down from D₁ to D₂ by exactly $1.50.
New equilibrium: quantity falls to 450 slices. The market price (what sellers receive) drops to P_S = $9.50. Buyers pay a total of P_B = $9.50 + $1.50 = $11.00.
The tax wedge is P_B minus P_S = $11.00 minus $9.50 = $1.50, which equals the tax.
Notice: buyers pay $1.00 more than before ($11.00 vs $10.00) and sellers receive $0.50 less ($9.50 vs $10.00). The $1.50 tax is shared, not borne entirely by either side.
Tags: tax on sellers, supply shift, seller tax burden
When a tax is levied on sellers, it shifts the supply curve upward by the amount of the tax.
Same pizza example: a $1.50 per-slice tax on sellers.
Sellers must now send $1.50 per slice to the government. The effective price they receive is $1.50 lower than the market price. To induce sellers to supply the same quantity, the market price must rise by $1.50. This shifts the supply curve up from S₁ to S₂ by exactly $1.50.
New equilibrium: quantity falls to 450 slices. Buyers pay P_B = $11.00. Sellers receive the market price minus the tax: P_S = $11.00 minus $1.50 = $9.50.
The tax wedge is again $1.50, and the split is identical: buyers pay $1.00 more, sellers receive $0.50 less.
Tags: tax equivalence, statutory vs economic incidence, irrelevance of legal assignment
This is one of the most important results in the chapter.
Whether the $1.50 tax is placed on buyers or on sellers, the new equilibrium quantity is 450 slices, buyers pay $11.00, and sellers receive $9.50.
The only difference is who physically sends the $1.50 to the government. When the tax is on buyers, buyers pay $11.00 ($9.50 market price + $1.50 tax). When the tax is on sellers, sellers receive $11.00 from buyers and remit $1.50, keeping $9.50.
The economic burden is identical in both cases. Statutory incidence (who the law tells to write the cheque) does not determine economic incidence (who actually bears the cost).
Tags: payroll tax, FICA, labour market, wage wedge, employer share, employee share
Payroll taxes apply the same framework to the labour market, where the "price" is the wage.
By law, half of the U.S. payroll tax is paid by firms (out of revenues) and half by workers (deducted from pay cheques). Congress structured it as a 50/50 split.
In practice, the economic incidence need not follow the 50/50 legal split. The tax creates a wedge between the wage firms pay and the wage workers take home.
The wage firms pay rises (the cost of employing a worker goes up).
The wage workers receive falls (take-home pay drops).
The actual split of the burden between firms and workers depends on the relative elasticities of labour supply and labour demand, not on the statutory 50/50 rule.
This is a direct application of the equivalence result: Congress cannot legislate how the burden is shared. Market forces (elasticity) determine it.
Tags: elasticity, tax burden, elastic supply, inelastic demand, luxury tax, yacht tax, 1990 luxury tax
The central rule: the tax burden falls more heavily on the side of the market that is less elastic.
Elasticity measures how easily buyers or sellers can leave a market and how good their alternatives are.
Highly elastic: good alternatives, willing to leave the market, and therefore able to avoid the tax burden.
Inelastic: poor alternatives, stuck in the market, and therefore forced to bear more of the tax.
Case 1: supply is more elastic than demand.
Sellers can leave the market more easily than buyers. Buyers are stuck and bear most of the tax. On the diagram, P_B rises sharply above the no-tax price while P_S falls only slightly.
Case 2: demand is more elastic than supply.
Buyers can leave the market more easily than sellers. Sellers are stuck and bear most of the tax. On the diagram, P_S falls sharply below the no-tax price while P_B rises only slightly.
Case study: the 1990 U.S. luxury tax.
Congress imposed a tax on yachts, private aeroplanes, furs, jewellery, and expensive cars, aiming to raise revenue from the wealthy.
For luxury items, demand is quite elastic (wealthy buyers can choose not to buy a yacht) while supply is relatively inelastic (yacht builders cannot easily switch to making something else in the short run).
Result: the burden fell largely on the suppliers (yacht builders, jewellers, and their workers), not on the wealthy buyers Congress intended to tax.
By 1993, most of the luxury tax was repealed because it was hurting workers in those industries rather than taxing the rich.
Tax on buyers (pizza market): D₁ shifts down by the tax amount to D₂. New equilibrium at the intersection of S₁ and D₂. Read P_B as the point on D₁ directly above the new equilibrium quantity (the old demand curve tells you the full price buyers pay). Read P_S at the new equilibrium on S₁. The vertical gap between P_B and P_S equals the tax.
Tax on sellers (pizza market): S₁ shifts up by the tax amount to S₂. New equilibrium at the intersection of S₂ and D₁. Read P_B at the new equilibrium on D₁. Read P_S as the point on S₁ directly below the new equilibrium quantity. Same P_B, P_S, and Q as the tax-on-buyers case.
Elasticity and incidence, Case 1 (supply more elastic): A relatively flat S curve and a relatively steep D curve. The tax wedge shows P_B rising far above the no-tax price and P_S falling only a little. Buyers bear most of the burden.
Elasticity and incidence, Case 2 (demand more elastic): A relatively flat D curve and a relatively steep S curve. The tax wedge shows P_S falling far below the no-tax price and P_B rising only a little. Sellers bear most of the burden.
Luxury tax (yacht market): Elastic demand (flat D), inelastic supply (steep S). The sellers' share of the tax wedge is much larger than the buyers' share.
Payroll taxes (Social Security and Medicare in the U.S.) are split 50/50 by law, but most labour economists believe workers bear the majority of the burden because labour supply is relatively inelastic for most workers (people need to work).
The 1990 luxury tax demonstrated that a tax designed to hit wealthy buyers can end up hurting producers and their employees when demand is elastic and supply is inelastic. This is why policymakers need to consider elasticity, not just who the tax is "aimed at."
Students often think a tax on sellers is paid entirely by sellers and a tax on buyers is paid entirely by buyers. The equivalence result shows this is wrong: the economic incidence is the same regardless of statutory incidence.
Students sometimes confuse the direction of the curve shift. A tax on buyers shifts the demand curve down (not up). A tax on sellers shifts the supply curve up (not down). The shift is always in the direction that makes the taxed party worse off at any given quantity.
Students often assume the tax burden is always split 50/50. The split depends entirely on relative elasticities and is almost never exactly equal.
Students sometimes think Congress can choose who bears the burden of a payroll tax by changing the legal split. It cannot. Only elasticity determines the economic split.
⚠️ You will almost certainly be asked to show that a tax on buyers and a tax on sellers produce the same equilibrium P_B, P_S, and Q. Be able to draw both diagrams and demonstrate the equivalence.
⚠️ Expect a question where you are given elasticity information and asked to determine which side bears the larger share of a tax. The rule: the less elastic side bears more.
⚠️ The luxury tax case study is a favourite exam scenario. Be ready to explain why the burden fell on yacht builders rather than wealthy buyers.
⚠️ The lecture notes flag this specific formula for exam purposes: Effective price for seller = Product cost minus Taxes. Make sure you can compute P_S given the market price and the tax amount.
True or false: A tax on buyers shifts the supply curve. (False, it shifts the demand curve down.)
Fill in the blank: The difference between the price buyers pay and the price sellers receive after a tax is called the tax ______. (wedge)
True or false: If demand is more elastic than supply, sellers bear the larger share of the tax. (True.)
Fill in the blank: The division of the tax burden between buyers and sellers is called tax ______. (incidence)
True or false: Congress can determine the economic incidence of a payroll tax by setting the legal split between employers and employees. (False, economic incidence depends on elasticity.)
Q: A $2.00 per-unit tax is imposed on sellers in a market where the equilibrium price was $20.00 and the equilibrium quantity was 1,000 units. After the tax, the market price rises to $21.20. What is P_B, P_S, and who bears the larger share of the tax?
A: P_B = $21.20 (the price buyers pay). P_S = $21.20 minus $2.00 = $19.20 (the price sellers keep). Buyers' share = $1.20 ($21.20 minus $20.00). Sellers' share = $0.80 ($20.00 minus $19.20). Buyers bear the larger share, indicating demand is less elastic than supply in this market.
Q: Suppose the government replaces the tax on sellers with an identical $2.00 tax on buyers. What changes?
A: The equilibrium quantity, P_B, and P_S remain exactly the same. The only change is who sends the $2.00 to the government. Under the buyer tax, buyers pay the market price plus $2.00. Under the seller tax, sellers receive the market price and remit $2.00. The economic outcome is identical.
Q: In the 1990 luxury tax on yachts, demand was elastic and supply was inelastic. Who bore most of the tax, and why was this an unintended consequence?
A: Yacht builders (sellers) bore most of the tax because their supply was inelastic: they could not easily switch to producing other goods. Congress intended the tax to fall on wealthy buyers, but because wealthy buyers had elastic demand (they could simply choose not to buy a yacht), buyers avoided most of the burden. The tax ended up hurting workers in the yacht-building industry, and most of it was repealed by 1993.
Q: A payroll tax is split 50/50 by law between employer and employee. If labour supply is very inelastic and labour demand is moderately elastic, who bears most of the tax?
A: Workers bear most of the tax. Because labour supply is very inelastic (workers cannot easily leave the market), they absorb the larger share of the burden regardless of the statutory 50/50 split. The legal assignment does not determine economic incidence.
Tax incidence builds directly on elasticity (Chapter 5): you cannot determine who bears the burden without knowing relative elasticities. It also connects forward to welfare economics and deadweight loss (Chapter 7 and beyond), where you will measure the total efficiency cost of taxes using consumer surplus, producer surplus, and the lost trades that no longer happen. The price controls material from the first half of this lecture uses the same supply-and-demand framework and the same logic of binding vs non-binding government interventions.
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