The Issue of Fiscal Incidence in Hal Varian's Textbook: Austrian, or not Austrian?

Economics Economics Questions
1

Hello,

I’m currently reading Hal Varian’s intermediate micro textbook. I have been very amazed to find in this book an analysis of the fiscal incidence issue which seems to me very similar to the Austrian one.

Indeed, in the 1st chapter, the author writes,

Let’s consider another example of a surprising comparative statics analysis: the effect of an apartment tax. Suppose that the city council decides that there should be a tax on apartments of $50 a year. Thus each landlord will have to pay $50 a year to the city for each apartment that he owns. What will this do to the price of apartments? Most people would think that at least some of the tax would get passed along to apartment renters. But, rather surprisingly, that is not the case. In fact, the equilibrium price of apartments will remain unchanged! In order to verify this, we have to ask what happens to the demand curve and the supply curve. The supply curve doesn’t change—there are just as many apartments after the tax as before the tax. And the demand curve doesn’t change either, since the number of apartments that will be rented at each different price will be the same as well. If neither the demand curve nor the supply curve shifts, the price can’t change as a result of the tax. Here is a way to think about the effect of this tax. Before the tax is imposed, each landlord is charging the highest price that he can get that will keep his apartments occupied. The equilibrium price p_ is the highest price that can be charged that is compatible with all of the apartments being rented. After the tax is imposed can the landlords raise their prices to compensate for the tax? The answer is no: if they could raise the price and keep their apartments occupied, they would have already done so. If they were charging the maximum price that the market could bear, the landlords couldn’t raise their prices any more: none of the tax can get passed along to the renters. The landlords have to pay the entire amount of the tax. This analysis depends on the assumption that the supply of apartments remains fixed.

But, then, in the chapter 2, he holds that,

How does a quantity tax affect the budget line of a consumer? From the viewpoint of the consumer the tax is just like a higher price. Thus a quantity tax of t dollars per unit of good 1 simply changes the price of good 1 from p1 to p1 + t. As we’ve seen above, this implies that the budget line must get steeper. (p.27)

If good 1 has a price of p1 but is subject to a sales tax at rate Ƭ, then the actual price facing the consumer is (1 + Ƭ)p1. The consumer has to pay p1 to the supplier and Ƭp1 to the government for each unit of the good so the total cost of the good to the consumer is (1 + Ƭ )p1. (p.27)

Can someone tell me,

1° If there is a diffference between the first excerpt and the Austrian theorem of fiscal incidence;

2° If the first quotation and the other two are compatible?

Thanks in advance.

(Some other things puzzle me in Varian’s book.)

2
  1. I have a q about the first excerpt. The supply is not determined by the price the buyer has to pay, but by how much the landlord is getting after taxes. To see this, if the price was originally, say. $1,000 a month, and tax of $999 a month was imposed, and that could not be passed along to the tenant, clearly many landlords would withdraw their houses from the market. Less supply means higher prices.

On the other hand, if the $999 tax was passed on to the tenants, clearly that raises prices right there..

Clearly the tax raises the price. How can he think otherwise?

  1. I’ve seen various discussions about whether a tax gets passed on to the consumer, or the producer has to take the hit [in agreement with his analysis, and for the same reason he presents]. I’m not sure about this one, would also like to know.

  2. Maybe the second excerpt assumes a case where the tax is imposed on the consumer directly from the govt, as opposed to the first one where it smacked on the seller.

3

I think your objection holds, but it holds only because it is extreme. The idea that leads to the Austrian theorem of tax incidence is that sellers have no reservation price ; that is, that the supply curve is vertical. In these conditions, the supply isn’t affected by a tax increase.

Now, if, as in your example, the tax increase is huge, the remaining benefit of the sellers can be so little that they may be induced to withdraw their products from the market, in order to keep them for their own use or to sell them latter.

But, with a “normal” tax increase, the sellers have no interest to withdraw the stock already produced.

4

Regarding your 3rd point: Indeed, in the first case, the tax is imposed on the seller/producter, and in the second, on the consumer, but I think (and, actually, it’s what the theorems argues) that the same reasoning applies in both cases: the seller has to determine how much the potential consumers are ready to put (including possible taxes) in order to purchase the good.

5

Imma just throw out there that this depends in large part whether or not the supply curve for rent is verticle in this instance (of course, because I spend all my time talking about the shapes of curves these days). I think that in the rent example your textbook is talking about it could be the case that there’s nothing more profitable the buildings could be used to do, so if taxes are increased then the supply curve won’t shift to the left because there’s nothing more that the apartments could be put to. Now if only apartments which are rented out had to pay the tax, then it would make sense for the landlords to pull out on the margin until the new price covered the tax.

Ironically I think your textbook is making one of the same errors that Rothbard did in Power and Market. Because landlords are working in a competitive environment landlords cannot change price at will to get the price that would maximize total revenue to landowners as a whole. However, if costs rise then this is no longer the case and some apartment owners will try to pull out in whatever way they can until the supply curve has shifted to cover the cost.

6

I disagree with the statement that the supply curve does not move. The decisions of consumers and suppliers are made on the margin. In the apartment rental market the average or median price may not change as there are contracts and it is very difficult to add supply. But the marginal buyer, that person looking to rent immediately after the tax would see the increase in price for the same property that a fellow could rent before the tax.

The supply curve is a preference curve and as such will respond to an increase in costs. And over time the curve will move. As the one fellow pointed out, the had the tax been $500000 then the supply curve would move dramatically and quickly. At $5,000,000 I bet that there will be lots of buildings accidently catching on fire or being donated to charities to get the owners out from paying the tax thus massively reducing supply. In the mean time the reality of the short term market allows government to fleece suppliers and not hurt current renters but only hurt marginal renters.

As for price adjustments there is an alternative for suppliers, which is to not supply the market thus creating a shortage leaving the prices unchanged.

7

…the supply curve is vertical.

Isn’t that begging the question? The book is going to prove changes in price don’t affect the suppliers by assuming it?

What is his proof that the supply curve is vertical?

As for stock already produced, the sellers may not withdraw the stock already produced, but there is a catch. Houses need constant upkeep. If the profit is not sufficient, the landlord will just let them rot away. This has happened many times when prices are not allowed to rise, aka rent control. Same thing will apply when the profit is reduced by a tax. The suppliers don’t care if the law forbids them to charge more than, say $200 a month [=rent control], or taxes away anything more than $200 a month.

Would the vertical supply curve be the answer to the contradiction in the book? First quote talking about vertical lines, second about diagonal lines?

8

Dave,

Well what I was thinking was that if the tax was on buildings, not on apartments, then the supply curve wouldn’t shift (now I think about it the curve wouldn’t need to be vertical and almost certainly wouldn’t be be) because there’s no more profitable use that they could be put to, landlords would be stuck and they couldn’t rid themselves of the apartment no matter how much the government was taxing them, the most they could hope for would be to try to abandon the properties they hold and legally disassociate themselves. Indeed now that I think about it this tax might actually increase the number of apartments as the costs of just having a building go up, so it might add more people into the market.

However, if the tax is merely on apartments, buildings that are being used to house a large number of people, then of course the supply curve would shift because there’s an alternative to being a landlord of an apartment, they could kick everyone else and just have a building rather than the taxed apartment and if their new variable costs in running the apartment were higher than the revenue received off of the apartment, then you bet the quantity of apartments would change.

9

Neodoxy,

Your wrote,

Imma just throw out there that this depends in large part whether or not the supply curve for rent is verticle in this instance (of course, because I spend all my time talking about the shapes of curves these days). I think that in the rent example your textbook is talking about it could be the case that there’s nothing more profitable the buildings could be used to do, so if taxes are increased then the supply curve won’t shift to the left because there’s nothing more that the apartments could be put to. Now if only apartments which are rented out had to pay the tax, then it would make sense for the landlords to pull out on the margin until the new price covered the tax.

So far, I agree. The tax incidence theorem asserts that prices won’t increase until the actual stock has been sold. But, indeed, the stock can be reduced in another way, namely, when the goods involved aren’t specific to the taxed use, by shifting them to another market.

Now, the Austrian theorem must be conceived of from the producer’s view point. Indeed, this theorem tells them what to answer if the government proposes a tax increase while assuring them “don’t worry, it will be painless: you just will have to increase your prices”.

So the issue is: is a tax increase really painless for the producer? And the answer could be: no, because, even if the sellers are able to shift their goods to another market, and thus avoid part of the burden, they will suffer some loss—indeed, the fact that the goods were primarily intended to the taxed market proves that they will be sold at a cheaper price on the second-best market.

Ironically I think your textbook is making one of the same errors that Rothbard did in Power and Market. Because landlords are working in a competitive environment landlords cannot change price at will to get the price that would maximize total revenue to landowners as a whole. However, if costs rise then this is no longer the case and some apartment owners will try to pull out in whatever way they can until the supply curve has shifted to cover the cost.

I’m not sure to understand correctly the second part of your argument, but I know George Reisman argues in the sense of the first part of your point. Indeed, he writes,

The role of cost of production, rather than elasticity of demand, in the determination of prices is further evident in such cases as an excise tax increase on cigarettes. Cigarettes are a good that is faced with a highly inelastic demand and which is produced by only a handful of firms. When the excise tax on cigarettes is increased, the price of cigarettes is correspondingly increased. At the higher price there is very little reduction in the quantity of cigarettes demanded, and the tobacco industry’s pretax sales revenues sharply increase. The tobacco industry raises its price when the excise tax is increased because that is a factor raising the costs of doing business of all producers and potential producers. In the absence of such a factor that increases costs to everyone, the tobacco industry would not be able to raise its price, despite the fact that if it could succeed in doing so all the firms would have sharply higher sales revenues and profits.

Now, there are two possibilities.

Either the producers form a cartel and use the weaker degree of elasticity at the industry level in order to increase the prices. In thus case, by hypothesis, they manage to increase their prices, but this rise is imputable to the cartel and not to the tax hike per se.

Either they don’t form a cartel and, thus, they can’t rise their prices. Indeed, because the demand hasn’t change, such a price hike would require that part of the stock remains unsold. So, if some producers increase their prices, some others may be trying to “free ride” on this rise in order to sold their whole stock at the higher price. So I conclude that, in the absence of a cartel (express or tacit), nobody will increase his prices.

10

Bogart,

I think I agree with two of your points, but I don’t believe it refutes in any way the Austrian theorem.

Yes, the curve will move “over time”: Rothbard clearly admits this point. What he says is only that, until all the stock has been sold, the prices have no reason to change.

And, yes, a tax as high as $500,000 or $5,000,000 is likely to immediately dry the market and to de-verticalize the supply curve. I suppose it was implicit that Rothbard didn’t deal with such huge tax hikes.

At the opposite, I don’t grasp how the marginal renter could be hurt during the short term.

11

Smiling Dave,

The supply curve can fairly be assumed to be vertical (with the reservations mentioned above) because, in a system of division of labor, the producers don’t have a great interest in the direct consumption of the goods they produce. So, regarding the stock already produced, their reservation price can be deemed to be very low.

I think your example of rent control is correct but can be classified in the same category as the “huge tax hikes”. I don’t know the rate of the house rents in your country, but I suppose that to tax away anything above $200 a month would be equivalent to a very important tax.