Taxes, Tax Incidence & Income Distribution

You’ll be able to

Analyze how a per-unit tax affects price, quantity, and total surplus
Determine tax incidence using the relative elasticities of supply and demand
Interpret the Lorenz curve and Gini coefficient as measures of income inequality

The effect of a per-unit tax

A per-unit (excise) tax drives a wedge between the price buyers pay and the price sellers receive. Whether levied on buyers or sellers, the tax raises the price buyers pay, lowers the price sellers keep, and reduces the quantity traded below the efficient level. It generates tax revenue (tax per unit × quantity) but also creates deadweight loss — the surplus lost on the mutually beneficial trades that no longer happen. Who legally pays the tax does not determine who actually bears its burden.

Tax incidence and elasticity

Tax incidence is how the burden of a tax is shared between buyers and sellers, and it depends on relative elasticity. The side that is more inelastic (less responsive to price) bears the larger share of the tax, because it cannot easily avoid the good. If demand is more inelastic than supply, consumers bear most of the burden; if supply is more inelastic, producers bear most. In the extreme, a perfectly inelastic side bears the entire tax. The legal assignment is irrelevant to this economic outcome.

Measuring income inequality

Governments also address the distribution of income. The Lorenz curve plots the cumulative share of income against the cumulative share of households (poorest to richest); perfect equality is a 45-degree line, and the more the curve bows away from it, the more unequal the distribution. The Gini coefficient summarizes this in a single number from 0 (perfect equality) to 1 (perfect inequality) — the ratio of the area between the Lorenz curve and the line of equality to the total area beneath the line. Progressive taxes and transfers can reduce measured inequality.

Tax incidence and inequality measures

Burden falls more on the more inelastic side · Gini = 0 (perfect equality) → 1 (perfect inequality)

Tax revenue = per-unit tax × quantity traded after the tax. The Lorenz curve bowing farther from the 45° line means a higher Gini coefficient.

Worked example

A $3 per-unit tax is imposed on a good. Before the tax, the equilibrium price was $10. After the tax, buyers pay $12 and sellers receive $9. How is the $3 tax burden split between buyers and sellers?

1.Buyers’ share = new price paid − old price = $12 − $10 = $2 per unit.
2.Sellers’ share = old price − new price received = $10 − $9 = $1 per unit.
3.Check: buyers’ $2 + sellers’ $1 = $3, the full tax.
4.Buyers bear the larger share ($2 of $3), indicating demand is more inelastic than supply here.

Answer: Buyers bear $2 of the $3 tax and sellers bear $1. Because buyers absorb the larger share, demand must be more inelastic than supply in this market — the more inelastic side always carries the heavier burden.

Checkpoint

A per-unit tax is placed on a good for which demand is highly inelastic and supply is highly elastic. Who bears the greater share of the tax burden?

Watch out

The legal assignment of a tax (on buyers vs. sellers) does not determine its economic incidence. The burden falls on the more inelastic side regardless of who writes the check. This statutory-vs-economic distinction is heavily tested.

Checkpoint

A country’s Lorenz curve bows farther away from the 45-degree line of perfect equality than it did a decade ago. This indicates that:

On the exam

On tax graphs, show the tax as a vertical wedge between the price buyers pay and sellers receive, then identify each side’s share and the deadweight-loss triangle. For inequality, remember: Lorenz curve farther from the 45° line ⇒ higher Gini ⇒ more inequality.

Answer the 2 checkpoints as you read.