Incidence analysis---it's all about the elasticities

Taxes and subsidies are opposite sides of the coin--and incidence analysis applies to both sides.

What IS incidence analysis, you may be asking?

When the government imposes a new tax, most thoughtful people who've studied economics expect that the burden of the tax will, in general, be split between the buyer and the seller.

The buyer will generally see his gross of tax price (the amount he actually pays) go up, and the seller will generally see her net of tax price (the amount she actually keeps, after the government collects its cut) go down.

Example: suppose the price of soda is $2 per liter. Then the government comes along and puts a tax of 50 cents a liter. After the dust clears, and we reach a new equilbrium, the tax-inclusive price that buyers pay might rise to $2.40 per liter. Sellers have to remit 50 cents of that to the government, so the tax-exclusive price (the amount they keep) has fallen to $1.90 a liter. In that case, we would say that buyers are paying 80% of the 50 cent tax (in the form of a higher gross price) and sellers are paying 20% of the 50 cent tax (in the form of a lower net price.)

What determines how the economic burden of the tax is split? That's the key question of incidence analysis.

It doesn't depend on who writes the check and mails it into the government.

In equilibrium, how the burden will be split depends on the relative elasticity of demand and supply.

What I always say to my students is:

Remember that E stands for Elasticity and Escape.

The more elastic side of the market is the side with more options for escaping the tax, so they won't wind up bearing as much of the burden.

The more inelastic side of the market has fewer options to escape the tax, so they will wind up bearing more of the burden.

Elasticity is all about the options. If soda drinkers have rigid and inflexible tastes, and can't bear to give up their soda, they may be fairly inelastic in their demand. If soda producers have lots of other businesses they could put their resources into making, then they may be fairly elastic in their supply.

So, in general, when a tax is imposed, the economic incidence of the tax is going to fall more heavily on the more inelastic side of the market, because they don't have many options to escape the tax.

Of course, you can apply the same analysis to determine the economic incidence of a subsidy--such as Cash for Clunkers. A Daily Kos post recounts the following story.

I returned this last week to go ahead and close a deal on a Prius and learned that they had none in stock due to demand from the Cash For Clunkers program (Good news. Glad to hear the program is working and sending people to the dealer). But when I asked pricing, I was told that due to increased demand, dealers were adding on $1,500 to $3,500 to MSRP (Bad news! Dealer is converting program dollars to profits).

Let's see if we can use economic incidence analysis to explain what's going on here.

Given that it's the end of the model year, the supply of cars that can qualify for the Cash for Clunkers incentive is probably pretty inelastic. The demand for cars is relatively much more elastic.

So, it's not surprising that dealers may be able to appropriate quite a bit of the benefit of the Cash for Clunkers subsidy in the form of higher prices than they would otherwise get.

If government puts a short term tax on cars, it would probably fall more heavily on sellers than on buyers. By the same token, if it puts as short term subsidy on cars, the subsidy will probably benefit sellers more than buyers. (And, of course, buyers that do not qualify for the subsidy may get negative benefits from the subsidy!)

Then again, the standard incidence analysis assumes that markets are in equilibrium, but in a time of recession, many markets are not in equilibrium, so the story can get a good bit more complicated. Another complication is that relative elasticities may differ in the short run vs. the long run.

But the same logic of tax incidence analysis applies to many other subsidies as well, not just Cash for Clunkers. A Tax Foundation post gives a number of other good examples:

We often see these types of issues in tax policy due to the fact that our tax code is routinely used as a tool to encourage and discourage various behaviors. The government can subsidize and industry or activity, but it can't mandate who benefits. Some examples: the mortgage interest deduction allows home owners to deduct their mortgage interest paid, but evidence and theory suggest that the subsidy leads to higher home prices and benefits sellers, high income buyers, and Realtors. State sales tax holidays eliminate the sales tax on certain goods for short periods of time, but evidence suggests that retailers could take advantage of the sales tax holiday frenzy by increasing prices before and during the sales tax holiday thereby capturing some of the benefit meant for consumers. Education subsidies flow at least partially to educational institutions in the form of increased tuition, reducing the benefit for students.