Tax wedge

The tax wedge is the deviation from the equilibrium price/quantity ($P^{*}$ and $Q^{*}$ , respectively) as a result of the taxation of a good. Because of the tax, consumers pay more for the good ($P_{c}$ ) than they did before the tax, and suppliers receive less for the good ($P_{s}$ ) than they did before the tax . Put differently, the tax wedge is the difference between what consumers pay and what producers receive (net of tax) from a transaction. The tax effectively drives a "wedge" between the price consumers pay and the price producers receive for a product.

Following from the Law of Supply and Demand, as the price to consumers increases, and the price received by suppliers decreases, the quantity that each wishes to trade will decrease. After a tax is introduced, a new equilibrium is reached, where consumers pay more $(P^{*}\rightarrow P_{c})$ , suppliers receive less $(P^{*}\rightarrow P_{s})$ , and the quantity exchanged falls $(Q^{*}\rightarrow Q_{t})$ . The difference between $P_{c}$ and $P_{s}$ will be equivalent to the size of the per-unit tax.

Implications of a tax wedge

The filled-in "wedge" created by a tax actually represents the amount of deadweight loss created by the tax. Deadweight loss is the reduction in social efficiency (producer and consumer surplus) from preventing trades for which benefits exceed costs. Deadweight loss occurs with a tax because a higher price for consumers, and a lower price received by suppliers, reduces the quantity of the good sold. Thus, the equilibrium quantity of a taxed good is lower than the equilibrium quantity when the same good is not taxed. The deadweight loss created by the tax is equal to ${1 \over 2}\times \ Tax\ \times (Q^{*}-Q_{t})$ , represented by the shaded triangle in the figure.
The economic incidence of a tax falls on the party that bears the actual cost of the tax. Put another way, economic incidence reflects the actual change in an individual's or firm's resources due to the tax. The statutory incidence of the tax is irrelevant to the economic incidence of the tax. In fact, the economic incidence is completely determined by the elasticity of supply and demand. Typically, both producers and consumers bear some portion of the economic incidence of the tax, but these portions do not have to be equal. The party with the more inelastic (steeper) curve bears more of the tax. For example, consumers of tobacco products typically bear more of the tax on tobacco, because they are addicted to the product and their consumption is not strongly affected by price changes (demand is inelastic). Producers bear more of the tax when supply is inelastic; for example, producers of beachfront hotels would bear more of a tax on hotels and accept lower prices for their product, because a change in price would not have a large effect on the quantity of beachfront hotels. These examples are illustrated graphically (right). The economic incidence on consumers is equal to $P_{c}-P^{*}$ , and the incidence on producers is equal to $P^{*}-P_{s}$ .