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- [Tyler] In the last lecture,
we showed that the legal incidence
of a tax does not determine
the economic incidence.
In this lecture,
we're going to talk
about how the economic incidence
of taxes actually is determined.
Who bears the burden of a tax?
Here is the rule for the economic
incidence of a tax.
The more elastic side
of the market will pay
a smaller share of the tax,
a smaller burden.
Similarly, the less elastic side
of the market
or rather the more inelastic side
of the market will pay
a greater share of the tax.
So more elastic
pays a smaller share,
less elastic pays a greater share.
I'm going to show you this
in a couple of diagrams
and then give you the intuition
for why it's the case.
Let's suppose
we can't remember the rule.
Is it the more elastic side
which bears the smaller share
of the tax or the greater share
of the tax?
Say we can't quite remember.
Well, no problem.
Let's just draw the diagram
and read it off as it happens.
For instance, let's draw a diagram
which has a pretty elastic
demand curve
and relatively speaking
a pretty inelastic supply curve.
Here's the price
when there's no tax.
Now let's look at what happens
when there is a tax
and we'll use our wedge method.
Here's the tax and the height
of the wedge gives us
the amount of the tax.
What do we do?
We drive this wedge
into the diagram
until the top of it
hits the demand curve
and the bottom of it
hits the supply curve
and then we just read
the answer off our diagram.
Point B, this tells us the price
paid by the buyer.
Point D, this tells us the price
received by the seller.
Let's compare.
When there was no tax,
the price paid by the buyer
was at A, and with the tax
the price to the buyer
goes up a little bit to point B.
The buyer isn't paying much
of a higher price.
On the other hand the seller
is receiving a lot less.
In this case, when demand
is more elastic than supply,
the demanders pay
a smaller share of the tax
and the suppliers
pay a larger share.
Therefore we can just read
off the diagram what happens
when demand
is more elastic than supply.
You don't have
to remember the rule,
you don't have to memorize it
because I'm going to give you
some intuition to make it easy
in just a moment.
You simply have to draw the diagram
and be able to read
the answer off the curves.
Let's look at another case.
In this case, we've drawn
a supply curve
which is very inelastic
and a demand curve
which is less elastic
than the supply curve.
Once again we're going
to take our tax wedge,
we're going to push it
into the diagram and what happens?
You can see it right here.
We just have to read it
off the diagram.
Now we see that compared
to when there was no tax,
the price to the buyer
has gone up a lot
and the price to the sellers
has gone down
by just a little bit.
When the supply
is more elastic than demand,
buyers pay the greater share
of the tax,
that is the price to the buyer
goes up more
than the price
to the sellers goes down.
The buyers pay more of the tax
when the supply curve
is more elastic.
Let's give some intuition.
You can always get the right answer
by drawing the curves.
And let's consider the intuition
for why that's the case.
So here's the intuition
for remembering the rule.
Think about elasticity
as a kind of escape.
The side of the market
which is the more elastic
can escape the tax more easily.
Why does that makes sense?
Remember what elastic demand means.
It means that demanders
have good substitutes
for the taxed good
and so they can escape the tax.
When the tax is high,
the demanders are going to say,
"We're just going to go buy
the substitutes.
We have plenty
of good substitutes."
On the other hand,
think about what it means
when the demand is inelastic.
It means that there
are no good substitutes
so it's hard to escape the tax.
What about the supply side,
elastic supply?
Well, that means the resources
which are used to produce
the taxed good,
they can easily be moved
to other industries.
The resources
can move around easily.
If you try to tax the industry
a lot then the land, the capital,
the workers in that industry
which were used
to produce the good,
they're just going to flow
to other industries
and so the suppliers
can relatively easily
escape the tax.
On the other hand,
if supply is inelastic
that means the resources used
to produce this good,
they really can only be used
to produce this good.
They're fixed, they're hard
to move around,
and those factors
are not that useful
for producing other goods,
so that makes it difficult
for the suppliers
when the supply curve is inelastic.
That means it's difficult
for the suppliers
to escape the tax.
What if the demanders
and the suppliers
are both pretty elastic?
Well, here's the thing.
Somebody has to pay the tax,
both sides can't escape the tax
at least if the good is going
to be bought and sold,
therefore the burden is determined
by the relative elasticities.
It's about which side has it easier
to escape the tax
and that side will pay
less of the tax.
The side which is less elastic,
they're going to pay
more of the tax
because that side finds it harder
to escape the tax.
So let's do an application,
say social security taxes.
Last time we showed
that the legal incidence
of social security taxes
has no bearing
on the economic incidence,
but we didn't say
what the economic incidence
actually is.
So let's do that now.
We're going to have the price
of labor up here, the wage,
and the quantity
of labor down here.
The whole question
now boils down to
is the demand for labor,
more elastic
than the supply of labor
or vice versa?
Think about the demanders
of labor, businesses,
what substitutes
for labor do they have?
If the price of labor goes up,
what can those businesses do?
What about the supply
of labor, the workers?
If their wage goes down,
what can they do?
If you think about it,
I think you'll see
that for most workers,
especially full time workers,
they don't really have a lot
of good substitutes for work.
Most workers need some kind of job.
Even if their wage goes down,
they're going to continue to work
because they need to pay the bills.
On the other hand,
the demanders of labor
if the wage were to go up,
they could substitute
capital for labor,
they could move their investments
to other countries.
They have quite a few
good substitutes.
So if that's actually how it works,
we should probably draw
the diagram like this
with a fairly inelastic
supply of labor
and a fairly elastic
demand for labor.
Economists have done studies
of this and on average
this is what they find.
So now think about your FICA taxes,
that's a tax on labor.
What's the effect of that?
Well, it's going to look
something like this.
Notice that the wage
paid by buyers of labor,
that's the wage paid
by the firms --
that goes up only a little bit.
On the other hand,
the wage received
by the suppliers of labor,
that is the wage
which the workers end up with,
that goes down by a lot.
And this makes perfect sense
when we have a very inelastic
supply of labor.
The laborers can't escape
the tax and, therefore,
they end up bearing
most of the burden of the tax.
This doesn't mean, by the way,
that we shouldn't have
social security taxes.
It may in fact be a good way
of forcing people to save
for their own future,
but this does mean
it is not a free lunch
for the workers.
The workers' wages will drop
because of the tax.
If we didn't have
the social security tax,
wages for most workers
would in fact be higher.
Here's one more application,
health insurance mandates.
Suppose that the government
requires employers
to provide health insurance
to their workers
as is now the case
for many employers
under the Affordable Care Act.
Who's going to pay for this?
Who will end up paying for this?
Is it primarily the employers
or primarily the workers?
It's really just the same analysis
as we had before.
A health insurance mandate
is quite similar to a tax.
A health insurance mandate
simply means that the employers
have to pay a higher wage,
but that's just, then,
the same as a tax.
What we just saw
is that if labor supply
is less elastic than labor demand,
which in many cases makes sense,
then in that case most
of the mandate
will actually be paid for
by the workers.
Real wages will fall.
Again this doesn't necessarily mean
that the mandate is a bad idea
but it does mean
it's not a free lunch
for the workers.
The workers end up paying
for their health care
through the medium of lower wages.
Taxes have a couple
of other effects
including the raising of revenue
and also creating
some dead weight loss.
Those are what we're going
to look at in the next lecture.
- [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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