IDEAS home Printed from https://ideas.repec.org/a/ebl/ecbull/eb-21-00257.html
   My bibliography  Save this article

The expenditure approach to income and substitution effects

Author

Listed:
  • Karl-Friedrich Israel

    (Western Catholic University)

Abstract

Visible substitutions between goods as a result of a price change have to occur insofar as the price elasticity of demand deviates from unity. A price-elastic demand leads to a larger expenditure share after a price decrease. This implies that the aggregate expenditure share for all other goods, including money in one's cash balance, has to decrease. A visible substitution takes place as the demand for other goods is reduced. Similarly, a price-inelastic demand for a specific good leads to a larger expenditure share after a price increase. The aggregate expenditure share of all other goods has to decrease and the consumer reduces demand for at least one other good. By following the expenditure approach to income and substitution effects it is shown that the conventional analysis of deadweight loss from taxation is misleading. The deadweight loss is underestimated when demand is inelastic and overestimated when it is elastic. Visible substitutions between goods as a result of a price change have to occur insofar as the price elasticity of demand deviates from unity. A price-elastic demand leads to a larger expenditure share after a price decrease. This implies that the aggregate expenditure share for all other goods, including money in one's cash balance, has to decrease. A visible substitution takes place as the demand for other goods is reduced. Similarly, a price-inelastic demand for a specific good leads to a larger expenditure share after a price increase. The aggregate expenditure share of all other goods has to decrease and the consumer reduces demand for at least one other good. By following the expenditure approach to income and substitution effects it is shown that the conventional analysis of deadweight loss from taxation is misleading. The deadweight loss is underestimated when demand is inelastic and overestimated when it is elastic. Visible substitutions between goods as a result of a price change have to occur insofar as the price elasticity of demand deviates from unity. A price-elastic demand leads to a larger expenditure share after a price decrease. This implies that the aggregate expenditure share for all other goods, including money in one's cash balance, has to decrease. A visible substitution takes place as the demand for other goods is reduced. Similarly, a price-inelastic demand for a specific good leads to a larger expenditure share after a price increase. The aggregate expenditure share of all other goods has to decrease and the consumer reduces demand for at least one other good. By following the expenditure approach to income and substitution effects it is shown that the conventional analysis of deadweight loss from taxation is misleading. The deadweight loss is underestimated when demand is inelastic and overestimated when it is elastic.

Suggested Citation

  • Karl-Friedrich Israel, 2022. "The expenditure approach to income and substitution effects," Economics Bulletin, AccessEcon, vol. 42(2), pages 431-446.
    • Handle: RePEc:ebl:ecbull:eb-21-00257
    as

    Download full text from publisher

    File URL: http://www.accessecon.com/Pubs/EB/2022/Volume42/EB-22-V42-I2-P38.pdf
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. James R. Hines, 1999. "Three Sides of Harberger Triangles," Journal of Economic Perspectives, American Economic Association, vol. 13(2), pages 167-188, Spring.
    2. repec:bla:econom:v:49:y:1982:i:195:p:355-59 is not listed on IDEAS
    3. Kay, J. A., 1980. "The deadweight loss from a tax system," Journal of Public Economics, Elsevier, vol. 13(1), pages 111-119, February.
    4. Diamond, P. A. & McFadden, D. L., 1974. "Some uses of the expenditure function in public finance," Journal of Public Economics, Elsevier, vol. 3(1), pages 3-21, February.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Auerbach, Alan J. & Hines, James Jr., 2002. "Taxation and economic efficiency," Handbook of Public Economics, in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 3, chapter 21, pages 1347-1421, Elsevier.
    2. Mickaël Beaud & Thierry Blayac & Patrice Bougette & Soufiane Khoudmi & Philippe Mahenc & Stéphane Mussard, 2013. "Estimation du coût d'opportunité des fonds publics pour l'économie française," Working Papers halshs-01077141, HAL.
    3. Charles L. Ballard & Don Fullerton, 1992. "Distortionary Taxes and the Provision of Public Goods," Journal of Economic Perspectives, American Economic Association, vol. 6(3), pages 117-131, Summer.
    4. Qidi Zhang & Leonard F.S. Wang & Yapo Yang, 2020. "Indirect taxation with shadow cost of public funds in mixed oligopoly," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 41(3), pages 415-425, April.
    5. Nan, Gehuang D., 1995. "An energy Btu tax alternative," Resource and Energy Economics, Elsevier, vol. 17(3), pages 291-305, November.
    6. Liqun Liu & Andrew J. Rettenmaier, 2004. "The Excess Burden of the Social Security Payroll Tax," Public Finance Review, , vol. 32(6), pages 631-650, November.
    7. Kathy Hayes & Shawna Grosskopf, 1985. "Measuring the Welfare Loss of Pension Mandates: A Methodology and Example," Public Finance Review, , vol. 13(1), pages 47-62, January.
    8. John Creedy, 2003. "The Excess Burden of Taxation and Why it (Approximately) Quadruples When the Tax Rate Doubles," Treasury Working Paper Series 03/29, New Zealand Treasury.
    9. Jerry A. Hausman, 1980. "Income and Payroll Tax Policy and Labor Supply," NBER Working Papers 0610, National Bureau of Economic Research, Inc.
    10. Desiderio Romero Jordán & José Félix Sanz Sanz, 2003. "El Impuesto sobre las Ventas Minoristas de Determinados Hidrocarburos. Una evaluación de sus efectos económicos," Hacienda Pública Española / Review of Public Economics, IEF, vol. 164(1), pages 49-73, march.
    11. van Soest, A.H.O., 1990. "Essays on micro-econometric models of consumer demand and the labour market," Other publications TiSEM be045d62-a73d-4d7c-a591-f, Tilburg University, School of Economics and Management.
    12. Fane, George & Ahammad, Helal, 2004. "Alternative ways of measuring and decomposing equivalent variation," Economic Modelling, Elsevier, vol. 21(1), pages 175-189, January.
    13. Hausman, Jerry A., 1985. "Taxes and labor supply," Handbook of Public Economics, in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 1, chapter 4, pages 213-263, Elsevier.
    14. Alan J. Auerbach & Harvey S. Rosen, 1980. "Will the Real Excess Burden Please Stand Up? (Or, Seven Measures in Search of a Concept)," NBER Working Papers 0495, National Bureau of Economic Research, Inc.
    15. Christopher C. Findlay & Robert L. Jones, 1982. "The Marginal Cost of Australian Income Taxation," The Economic Record, The Economic Society of Australia, vol. 58(3), pages 253-262, September.
    16. Hong Hwang & Chao-Cheng Mai & Ya-Po Yang, 2015. "Specific vs Ad Valorem Strategic Export Subsidies with Taxation Distortion," Review of Development Economics, Wiley Blackwell, vol. 19(4), pages 820-828, November.
    17. Tran, Chung & Wende, Sebastian, 2021. "On the marginal excess burden of taxation in an overlapping generations model," Journal of Macroeconomics, Elsevier, vol. 70(C).
    18. Bente Halvorsen, 2009. "Conflicting Interests in Environmental Policy-making?," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 44(2), pages 287-305, October.
    19. Kevin Boyle & Sapna Kaul & Ali Hashemi & Xiaoshu Li, 2015. "Applicability of benefit transfers for evaluation of homeland security counterterrorism measures," Chapters, in: Carol Mansfield & V. K. Smith (ed.), Benefit–Cost Analyses for Security Policies, chapter 10, pages 225-253, Edward Elgar Publishing.
    20. Michael A. Clemens & Claudio Montenegro & Lant Pritchett, 2016. "Bounding the Price Equivalent of Migration Barriers," Growth Lab Working Papers 67, Harvard's Growth Lab.

    More about this item

    Keywords

    substitution effect; income effect; expenditure share; deadweight loss; taxation; JEL-Codes: D60; H21;
    All these keywords.

    JEL classification:

    • D6 - Microeconomics - - Welfare Economics
    • H2 - Public Economics - - Taxation, Subsidies, and Revenue

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:ebl:ecbull:eb-21-00257. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: John P. Conley (email available below). General contact details of provider: .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.