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♪ [music] ♪

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

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of a tax does not determine
the economic incidence.

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In this lecture,
we're going to talk

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about how the economic incidence
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
incidence of a tax.

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The more elastic side
of the market will pay

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a smaller share of the tax,
a smaller burden.

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Similarly, the less elastic side
of the market

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or rather the more inelastic side
of the market will pay

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a greater share of the tax.

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So more elastic
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
in a couple of diagrams

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

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Let's suppose
we can't remember the rule.

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Is it the more elastic side
which bears the smaller share

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of the tax or the greater share
of the tax?

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

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Let's just draw the diagram
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
demand curve

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and relatively speaking
a pretty inelastic supply curve.

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Here's the price
when there's no tax.

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Now let's look at what happens
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
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
into the diagram

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until the top of it
hits the demand curve

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and the bottom of it
hits the supply curve

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and then we just read
the answer off our diagram.

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

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

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Let's compare.

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When there was no tax,
the price paid by the buyer

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was at A, and with the tax
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
of a higher price.

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On the other hand the seller
is receiving a lot less.

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In this case, when demand
is more elastic than supply,

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the demanders pay
a smaller share of the tax

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and the suppliers
pay a larger share.

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Therefore we can just read
off the diagram what happens

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when demand
is more elastic than supply.

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You don't have
to remember the rule,

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

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some intuition to make it easy
in just a moment.

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You simply have to draw the diagram
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
a supply curve

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which is very inelastic
and a demand curve

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which is less elastic
than the supply curve.

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

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we're going to push it
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
off the diagram.

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

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the price to the buyer
has gone up a lot

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and the price to the sellers
has gone down

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by just a little bit.

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When the supply
is more elastic than demand,

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buyers pay the greater share
of the tax,

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that is the price to the buyer
goes up more

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than the price
to the sellers goes down.

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The buyers pay more of the tax
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
by drawing the curves.

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

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So here's the intuition
for remembering the rule.

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Think about elasticity
as a kind of escape.

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The side of the market
which is the more elastic

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can escape the tax more easily.

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

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It means that demanders
have good substitutes

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for the taxed good
and so they can escape the tax.

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When the tax is high,
the demanders are going to say,

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

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We have plenty
of good substitutes."

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On the other hand,
think about what it means

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when the demand is inelastic.

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It means that there
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,
elastic supply?

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Well, that means the resources
which are used to produce

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the taxed good,
they can easily be moved

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to other industries.

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The resources
can move around easily.

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

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the workers in that industry
which were used

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to produce the good,
they're just going to flow

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to other industries
and so the suppliers

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can relatively easily
escape the tax.

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On the other hand,
if supply is inelastic

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that means the resources used
to produce this good,

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they really can only be used
to produce this good.

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They're fixed, they're hard
to move around,

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and those factors
are not that useful

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for producing other goods,
so that makes it difficult

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for the suppliers
when the supply curve is inelastic.

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That means it's difficult
for the suppliers

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to escape the tax.

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What if the demanders
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,
both sides can't escape the tax

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

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therefore the burden is determined
by the relative elasticities.

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

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and that side will pay
less of the tax.

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

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more of the tax
because that side finds it harder

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to escape the tax.

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

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Last time we showed
that the legal incidence

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of social security taxes
has no bearing

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on the economic incidence,
but we didn't say

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what the economic incidence
actually is.

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So let's do that now.

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

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and the quantity
of labor down here.

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The whole question
now boils down to

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is the demand for labor,
more elastic

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than the supply of labor
or vice versa?

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Think about the demanders
of labor, businesses,

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what substitutes
for labor do they have?

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

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What about the supply
of labor, the workers?

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If their wage goes down,
what can they do?

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If you think about it,
I think you'll see

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that for most workers,
especially full time workers,

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they don't really have a lot
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,
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,
the demanders of labor

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if the wage were to go up,

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they could substitute
capital for labor,

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they could move their investments
to other countries.

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They have quite a few
good substitutes.

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So if that's actually how it works,

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we should probably draw
the diagram like this

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with a fairly inelastic
supply of labor

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and a fairly elastic
demand for labor.

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Economists have done studies
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,
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
something like this.

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Notice that the wage
paid by buyers of labor,

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that's the wage paid
by the firms --

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that goes up only a little bit.

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On the other hand,
the wage received

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by the suppliers of labor,
that is the wage

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

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And this makes perfect sense
when we have a very inelastic

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supply of labor.

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The laborers can't escape
the tax and, therefore,

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they end up bearing
most of the burden of the tax.

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

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social security taxes.

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

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for their own future,
but this does mean

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it is not a free lunch
for the workers.

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The workers' wages will drop
because of the tax.

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If we didn't have
the social security tax,

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wages for most workers
would in fact be higher.

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Here's one more application,
health insurance mandates.

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Suppose that the government
requires employers

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to provide health insurance
to their workers

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as is now the case
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
or primarily the workers?

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

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A health insurance mandate
is quite similar to a tax.

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A health insurance mandate
simply means that the employers

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

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the same as a tax.

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What we just saw
is that if labor supply

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

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then in that case most
of the mandate

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will actually be paid for
by the workers.

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Real wages will fall.

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

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but it does mean
it's not a free lunch

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for the workers.

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The workers end up paying
for their health care

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through the medium of lower wages.

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Taxes have a couple
of other effects

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including the raising of revenue
and also creating

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some dead weight loss.

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

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- [Narrator] If you want
to test yourself,

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click Practice questions.

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Or if you're ready to move on,
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♪ [music] ♪