EIB Papers Volume 13. n°1/2008 - European Investment Bank

Box 1. Burden and excess burden of taxation – conventional approach
Figure B1 illustrates graphically the burden and the excess burden of taxation for a wage tax.
It pictures the demand for and supply of labour – measured in hours worked – as a function
of the wage rate. To be precise, D 0 shows firms’ demand for labour when there is no wage
tax. For simplicity, the demand schedule is assumed to be flat rather than downward sloping.
This implies that the marginal product of labour, which sets the wage firms are willing
to pay, does not fall when firms use more labour. S 0 shows households’ supply of labour.
A change in the supply of labour reflects a change in the hours worked by households already
working (intensive labour-supply response) and a change in the labour force participation
rate (extensive labour-supply response). The link between wages and labour supply is positive
for two related reasons. First, working more comes at the expense of leisure and, second,
the marginal value of leisure forgone rises with successive cuts in leisure. Thus, the wage
households require for working more and cutting leisure rises with an increase in the amount
of time allocated to working, or – equivalently – as wages go up, households wish to allocate
more of their time to work and less to leisure. The labour-supply curve might be steeper or
flatter than the one shown in the diagram. In fact, it might be backward-bending. These issues
will be taken up in Box 3 of Section 4.
The labour-market equilibrium resulting from the interactions between firms and households
yields a wage of BO , hours worked of L 0 and, thus, labour income equivalent to the area OL 0 AB.
As the labour-demand schedule represents the marginal product of labour, this area also
represents workers’ contribution to the value of output, and with constant returns to scale and
in the absence of other factor inputs it equals the value of output. This value can be readily
compared with the economic cost of producing it. This cost is given by the total value of
leisure forgone, which equals the area OL 0 AF under the labour-supply schedule. With the value
of output (OL 0 AB) exceeding the economic cost of generating it (OL 0 AF), there is thus a laboursupply
surplus of FAB. How does introducing a wage tax change this surplus and how does this
change relate to the burden and the excess burden of taxation?
Figure B1. Burden and excess burden of taxation – conventional approach
Wage
B
C
F
O
E A
D
L1
S0
D0
D1
L0 Labour supply and demand
(in hours worked)
A neat way of illustrating the impact of a wage tax assumes that firms make the tax payments
to the government. But as they do not want to foot the bill, they offer households a lower net
(after-tax) wage, and as firms demand for labour is completely elastic, they succeed in passing
EIB PAPERS Volume13 N°1 2008 89