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- [Tyler] In the last lecture,[br]we showed that the legal incidence

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of a tax does not determine[br]the economic incidence.

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In this lecture,[br]we're going to talk

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about how the economic incidence[br]of taxes actually is determined.

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Who bears the burden of a tax?

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Here is the rule for the economic[br]incidence of a tax.

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The more elastic side[br]of the market will pay

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a smaller share of the tax,[br]a smaller burden.

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Similarly, the less elastic side[br]of the market

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or rather the more inelastic side[br]of the market will pay

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a greater share of the tax.

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So more elastic[br]pays a smaller share,

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less elastic pays a greater share.

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I'm going to show you this[br]in a couple of diagrams

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and then give you the intuition[br]for why it's the case.

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Let's suppose[br]we can't remember the rule.

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Is it the more elastic side[br]which bears the smaller share

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of the tax or the greater share[br]of the tax?

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Say we can't quite remember.[br]Well, no problem.

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Let's just draw the diagram[br]and read it off as it happens.

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For instance, let's draw a diagram

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which has a pretty elastic[br]demand curve

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and relatively speaking[br]a pretty inelastic supply curve.

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Here's the price[br]when there's no tax.

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Now let's look at what happens[br]when there is a tax

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and we'll use our wedge method.

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Here's the tax and the height[br]of the wedge gives us

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the amount of the tax.

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What do we do?

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We drive this wedge[br]into the diagram

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until the top of it[br]hits the demand curve

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and the bottom of it[br]hits the supply curve

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and then we just read[br]the answer off our diagram.

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Point B, this tells us the price[br]paid by the buyer.

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Point D, this tells us the price[br]received by the seller.

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Let's compare.

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When there was no tax,[br]the price paid by the buyer

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was at A, and with the tax[br]the price to the buyer

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goes up a little bit to point B.

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The buyer isn't paying much[br]of a higher price.

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On the other hand the seller[br]is receiving a lot less.

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In this case, when demand[br]is more elastic than supply,

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the demanders pay[br]a smaller share of the tax

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and the suppliers[br]pay a larger share.

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Therefore we can just read[br]off the diagram what happens

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when demand[br]is more elastic than supply.

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You don't have[br]to remember the rule,

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you don't have to memorize it[br]because I'm going to give you

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some intuition to make it easy[br]in just a moment.

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You simply have to draw the diagram[br]and be able to read

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the answer off the curves.

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Let's look at another case.

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In this case, we've drawn[br]a supply curve

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which is very inelastic[br]and a demand curve

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which is less elastic[br]than the supply curve.

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Once again we're going[br]to take our tax wedge,

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we're going to push it[br]into the diagram and what happens?

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You can see it right here.

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We just have to read it[br]off the diagram.

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Now we see that compared[br]to when there was no tax,

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the price to the buyer[br]has gone up a lot

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and the price to the sellers[br]has gone down

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by just a little bit.

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When the supply[br]is more elastic than demand,

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buyers pay the greater share[br]of the tax,

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that is the price to the buyer[br]goes up more

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than the price[br]to the sellers goes down.

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The buyers pay more of the tax[br]when the supply curve

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is more elastic.

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Let's give some intuition.

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You can always get the right answer[br]by drawing the curves.

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And let's consider the intuition[br]for why that's the case.

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So here's the intuition[br]for remembering the rule.

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Think about elasticity[br]as a kind of escape.

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The side of the market[br]which is the more elastic

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can escape the tax more easily.

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Why does that makes sense?[br]Remember what elastic demand means.

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It means that demanders[br]have good substitutes

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for the taxed good[br]and so they can escape the tax.

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When the tax is high,[br]the demanders are going to say,

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"We're just going to go buy[br]the substitutes.

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We have plenty[br]of good substitutes."

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On the other hand,[br]think about what it means

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when the demand is inelastic.

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It means that there[br]are no good substitutes

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so it's hard to escape the tax.

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What about the supply side,[br]elastic supply?

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Well, that means the resources[br]which are used to produce

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the taxed good,[br]they can easily be moved

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to other industries.

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The resources[br]can move around easily.

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If you try to tax the industry[br]a lot then the land, the capital,

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the workers in that industry[br]which were used

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to produce the good,[br]they're just going to flow

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to other industries[br]and so the suppliers

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can relatively easily[br]escape the tax.

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On the other hand,[br]if supply is inelastic

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that means the resources used[br]to produce this good,

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they really can only be used[br]to produce this good.

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They're fixed, they're hard[br]to move around,

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and those factors[br]are not that useful

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for producing other goods,[br]so that makes it difficult

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for the suppliers[br]when the supply curve is inelastic.

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That means it's difficult[br]for the suppliers

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to escape the tax.

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What if the demanders[br]and the suppliers

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are both pretty elastic?

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Well, here's the thing.

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Somebody has to pay the tax,[br]both sides can't escape the tax

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at least if the good is going[br]to be bought and sold,

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therefore the burden is determined[br]by the relative elasticities.

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It's about which side has it easier[br]to escape the tax

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and that side will pay[br]less of the tax.

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The side which is less elastic,[br]they're going to pay

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more of the tax[br]because that side finds it harder

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to escape the tax.

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So let's do an application,[br]say social security taxes.

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Last time we showed[br]that the legal incidence

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of social security taxes[br]has no bearing

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on the economic incidence,[br]but we didn't say

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what the economic incidence[br]actually is.

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So let's do that now.

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We're going to have the price[br]of labor up here, the wage,

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and the quantity[br]of labor down here.

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The whole question[br]now boils down to

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is the demand for labor,[br]more elastic

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than the supply of labor[br]or vice versa?

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Think about the demanders[br]of labor, businesses,

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what substitutes[br]for labor do they have?

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If the price of labor goes up,[br]what can those businesses do?

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What about the supply[br]of labor, the workers?

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If their wage goes down,[br]what can they do?

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If you think about it,[br]I think you'll see

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that for most workers,[br]especially full time workers,

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they don't really have a lot[br]of good substitutes for work.

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Most workers need some kind of job.

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Even if their wage goes down,[br]they're going to continue to work

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because they need to pay the bills.

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On the other hand,[br]the demanders of labor

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if the wage were to go up,

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they could substitute[br]capital for labor,

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they could move their investments[br]to other countries.

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They have quite a few[br]good substitutes.

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So if that's actually how it works,

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we should probably draw[br]the diagram like this

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with a fairly inelastic[br]supply of labor

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and a fairly elastic[br]demand for labor.

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Economists have done studies[br]of this and on average

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this is what they find.

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So now think about your FICA taxes,[br]that's a tax on labor.

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What's the effect of that?

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Well, it's going to look[br]something like this.

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Notice that the wage[br]paid by buyers of labor,

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that's the wage paid[br]by the firms --

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that goes up only a little bit.

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On the other hand,[br]the wage received

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by the suppliers of labor,[br]that is the wage

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which the workers end up with,[br]that goes down by a lot.

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And this makes perfect sense[br]when we have a very inelastic

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supply of labor.

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The laborers can't escape[br]the tax and, therefore,

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they end up bearing[br]most of the burden of the tax.

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This doesn't mean, by the way,[br]that we shouldn't have

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social security taxes.

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It may in fact be a good way[br]of forcing people to save

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for their own future,[br]but this does mean

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it is not a free lunch[br]for the workers.

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The workers' wages will drop[br]because of the tax.

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If we didn't have[br]the social security tax,

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wages for most workers[br]would in fact be higher.

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Here's one more application,[br]health insurance mandates.

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Suppose that the government[br]requires employers

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to provide health insurance[br]to their workers

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as is now the case[br]for many employers

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under the Affordable Care Act.

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Who's going to pay for this?

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Who will end up paying for this?

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Is it primarily the employers[br]or primarily the workers?

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It's really just the same analysis[br]as we had before.

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A health insurance mandate[br]is quite similar to a tax.

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A health insurance mandate[br]simply means that the employers

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have to pay a higher wage,[br]but that's just, then,

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the same as a tax.

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What we just saw[br]is that if labor supply

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is less elastic than labor demand,[br]which in many cases makes sense,

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then in that case most[br]of the mandate

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will actually be paid for[br]by the workers.

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Real wages will fall.

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Again this doesn't necessarily mean[br]that the mandate is a bad idea

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but it does mean[br]it's not a free lunch

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for the workers.

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The workers end up paying[br]for their health care

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through the medium of lower wages.

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Taxes have a couple[br]of other effects

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including the raising of revenue[br]and also creating

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some dead weight loss.

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Those are what we're going[br]to look at in the next lecture.

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- [Narrator] If you want[br]to test yourself,

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click Practice questions.

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Or if you're ready to move on,[br]just click Next Video.

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