On average, families pay more than 40% of their income in taxes, including income, property, estate, sales, and excise taxes. (An excise tax is a sales tax applied to a specific product, such as gasoline or tobacco.) Add to this the taxes that are embedded into the goods and services we buy, such as tariffs (taxes) on imports, tourism taxes, and airport security taxes, and it’s no wonder that taxes are a perennial issue of debate among policymakers and their constituents.

Nobody likes paying taxes, but they are necessary to provide many of the public goods and services (such as roads, national defense, police protection, public education, clean air, and parks) from which everybody receives some benefit. The questions economists deal with are how to determine the efficient level of taxation and what is the most efficient way to reach that level.

Taxes can be separated into two general categories: taxes on income sources and taxes on spending. We now study how the economic burden of both categories of taxes can vary depending on how the tax policy is designed (in the case of income) and on the elasticity of the good or service being purchased (in the case of spending).

We begin by studying the various ways taxes are collected on income.

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Taxes on income sources constitute the largest source of revenues for the federal government and many state governments. The most common types of taxes include individual income tax, payroll tax (such as FICA, also known as the Social Security tax), corporate income tax, dividend tax (taxes on earnings from financial assets), and capital gains tax (taxes on the rising values of assets such as property and financial instruments when sold).

Much of the debate on the economic burden of income taxes focuses on whether taxes are progressive, flat, or regressive with respect to income earned. Progressive taxes are those that rise in burden as income increases. Flat taxes take a constant percentage of one’s income. Regressive taxes fall in burden as income increases, which means that individuals with lower incomes pay a greater percentage of their income in taxes than individuals with higher incomes. A type of regressive tax is called a lump-sum tax, which takes a fixed amount of tax regardless of income earned, and therefore falls in percentage as income rises. Table 3 lists the three categories of taxes and provides an example of an actual tax that falls within each category.

The typical household pays a substantial amount of taxes on goods and services. Almost everybody pays taxes on goods and services purchased, homeowners pay property taxes each year on the value of their homes, and all sorts of excise taxes exist on everything from car rentals and hotel stays to gasoline and wireless service plan purchases.

Although income taxes typically represent the largest burden on most households, taxes on spending are sometimes larger for certain groups of people. For example, households with very low incomes often pay little to no income taxes, but pay a sizeable portion of their income in sales and excise taxes. Similarly, wealthy households often receive most of their income by way of investment earnings, which are taxed at a lower rate than traditional income earnings. For these households, taxes paid on property (often on multiple homes) and luxury taxes (on yachts and other expensive toys) may constitute a larger portion of their tax burden.

In sum, taxes on spending are not trivial, and elasticity plays an important role in determining the impact of these various taxes on individuals and businesses. Economists studying taxes are interested in the incidence of taxation, which refers to who bears the economic burden of a tax. Although statutes determine what is taxed and who must pay various taxes, the individuals or businesses paying a tax may not be the ones bearing its economic burden. This burden can be shifted onto others.

Let’s analyze how the elasticity of a good or service can affect the incidence of taxation. To simplify the analysis, we will focus on excise taxes.

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Let us consider what happens when an excise tax is levied on a product such as airline tickets. Panel A of Figure 7 shows the market before an excise tax is imposed. The initial supply curve S₀ is supply before the tax and demand curve D₀ reflects demand. The market is in equilibrium at point e, at which 3,000 tickets are sold for $200 each. At equilibrium, consumer and producer surplus are substantial, with no deadweight loss because the market is operating efficiently.

In panel B, we now add a per unit tax of $20 paid by the airline. This, in effect, adds $20 to the cost of each airline ticket and adds a wedge between what consumers pay and what airlines receive. Supply curve S₀ therefore shifts upward by this amount, to S₀ + tax. The new supply curve runs parallel to S₀, with the distance the curve has shifted (ac) equaling the $20 tax per ticket collected by the government.

Assuming demand remains constant at D₀, the new equilibrium is at point a, with 2,000 tickets sold for a price of $210. The airline receives $210 per ticket, of which it must send $20 to the government, keeping $190 for itself. In this case, the airline shifted half of the tax burden ($10 of the $20 tax) onto consumers. Meanwhile, the government collects the $20 tax on the 2,000 tickets. This amount ($20 × 2,000 = $40,000) is represented by the blue area. Consumer surplus now equals the area above the blue section, and producer surplus equals the area below it. Note that consumers and producers lose surplus equal not only to the revenue gained by the government but also to area cae, which represents a deadweight loss. Although this area is lost to society as a result of the tax, how the tax revenues are used to benefit society determines whether society is better or worse off with the tax.

In this example, consumers and producers share the tax burden equally, but that is not always the case, as we’ll see next.

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Earlier in the chapter, we learned that inelastic demand means that consumers react less strongly to price changes, while elastic demand means that consumers react strongly to price changes. The same is true of how producers react when supply is inelastic or elastic. Using this knowledge, we can examine how consumers and producers react when prices of goods and services change due to a tax.

Figure 8 shows a market for sparklers, one in which consumer demand is inelastic, while supply is relatively elastic. In this situation, how would a tax affect the equilibrium price in this market? Like our previous analysis, the supply curve S₀ shifts to S_0+tax, moving the equilibrium point from e to g at a new equilibrium price of $4.00.

Compared to the equilibrium prior to the tax, consumers pay an additional $1.00 for each unit, but producers end up bearing a much smaller burden of 25 cents. Because consumers were less sensitive to changes in prices than producers, producers were able to shift a greater portion of the tax forward to consumers.

Therefore, we can generalize about the effects of elasticity on the tax burden as follows: For a given supply of some products, the lower the price elasticity of demand, the greater the share of the total tax burden shifted to consumers. Likewise, for a given demand of some products, the higher the price elasticity of supply, the greater the share of the total tax burden shifted to consumers. In sum, when demand for a good is inelastic while the supply of a good is elastic, consumers will end up bearing most of the burden of a tax.

Naturally, if inelastic demand and elastic supply shift the tax burden toward consumers, the opposite would be true when demand is elastic and supply is inelastic. Figure 9 again shows the market for sparklers, but this time demand is relatively elastic (flat) while supply is relatively inelastic (steep). When an excise tax of $1.25 per unit is levied, the equilibrium moves from point e to g. At the new equilibrium, consumers pay $3.25 per unit (or 25 cents per unit more than before the tax), while producers receive $2.00 per unit (or $1 per unit less than before the tax). In this case, because consumers are more sensitive to price changes, producers are less able to shift the tax to consumers, resulting in producers bearing the majority of the tax burden.

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Just like the previous example, we can generalize about the effects of elasticity when it causes a larger tax burden on producers. The higher the price elasticity of demand and the lower the price elasticity of supply, the lower the share of the total tax burden shifted to consumers. Therefore, when demand for a good is elastic while the supply is inelastic, producers will end up bearing most of the burden of a tax.

Note what happens in all of the tax cases described. Figure 7, Figure 8 and Figure 9 show that whenever a tax is added, the tax moves the market away from its equilibrium point, regardless of whether the tax is borne by consumers, producers, or both. All taxes generate a tax wedge, resulting in a deadweight loss to society. Does deadweight loss vary based on elasticity?

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Generally, the more elastic the demand or supply, the greater is the total deadweight loss to society. Why is that? We can deduce this intuitively by understanding that higher elasticities indicate a larger response by both consumers and producers in terms of the quantity demanded and supplied, respectively. Therefore, larger responses to price changes tend to move the equilibrium quantity farther from the pre-tax equilibrium, generating a larger deadweight loss.

The last three chapters have given us the powerful tools of supply and demand analysis. Elasticity is important because it captures the complex relationships among prices, quantity demanded, and total revenues in just two words: “elastic” and “inelastic”. When demand is inelastic and some incident marginally reduces supply, policymakers (and now you) know that price will go up substantially, although consumers will continue to purchase the product. Again, this is what happens when any inelastic product rises in price. When tuition increases, students continue to purchase roughly the same number of credits as before; thus, revenues collected by universities rise substantially in the short run.

If, however, demand is elastic and the same incident reduces supply, prices will rise, but by a smaller amount, and output and employment will fall a lot more. If weather conditions in California and Florida ruin the orange crop, reducing the supply and increasing the price of orange juice, consumers will readily substitute other juices. As a result, output, employment, and revenues will decline in the orange industry.

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