Tax Incidence

Also known as, who bears the burden of taxation?

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What do we get from a first pass at the data?

A first (partly naïve) pass indicates that U.S. federal income tax is paid primarily by the rich: in 2006 data, the top 20% of income earners paid 84.2% of the taxes, and the top 1% alone paid 36.7% of the taxes. The bottom half of income earners paid negative (!) taxes in total.

This reflects both the progressivity of the tax system, and the concentration of income in the United States.

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Total tax burdens: Still a first pass.

Federal personal income taxes are just part of the federal tax system. How do we assign burdens of…

– Federal corporate income taxes– Payroll taxes– Excise taxes– Estate and gift taxes– Other taxes (e.g., tariffs)

The payroll tax is particularly problematic, since subsequent benefits are tied to tax payments. Not clear whether it should be included.

One way of doing this: assign tax burdens based on arbitrary assumptions (corporate tax paid by owners of capital, payroll tax paid by workers, excise taxes paid by consumers, estate tax paid by decedents). This assignment produces:

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Might anything be wrong here?

Well yes, because many assumptions – and potentially problematic definitions – have gone into calculating these tax burdens. For example, who says that the burden of estate taxes falls only on those who receive, and not those who give? Or that the corporate tax burden is borne only by owners of capital, and not by workers or consumers?

The fundamental point is that it is a mistake to attribute tax burdens to those who remit the taxes, since the burden may lie elsewhere.

– For example, the burden of an excise tax may in part be borne by the seller, in the form of lower sales prices.

– Or if the government increases your tax rate, your wage may rise in part to compensate you, reflecting that, in the market, providers of services like yours will demand certain after-tax compensation.

– It is natural to forget about the determination of income in thinking about tax burdens, but it is a mistake to do so, since taxes may well influence relative pretax incomes.

Fortunately, there are undying principles that can – and will – guide our inquiry into who actually bears tax burdens.

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Tax Incidence: Five Principles

Who cares who pays? People pay taxes. Inelasticity is expensive. Small things can be big. In general, anything can happen.

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Who cares who pays?

This is the principle that it does not matter – for anything – whether the seller or the buyer has the formal tax obligation, and therefore remits the revenue to the government.

– Total tax revenue is unaffected either way.– Efficiency is the same either way.– The burden on consumers is the same.– The burden on sellers is the same.

In short, it really does not matter. Note: this is NOT intuitive. Social Security example: tax is paid

half (7.65%) by employees, half (7.65%) by employers – BUT THIS DIVISION DOES NOT MATTER, as long as prices are set by supply and demand.

– Proposed Social Security reforms in 1990 and at other times.– Recent temporary reductions in worker contributions, though not employer

contributions, to social security payroll taxes.

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How can we be sure this works?

Think about there being a “tax jar” at the counter. In one regime, the customer pays for the good, then puts taxes in the jar. Alternatively, the seller can collect the tax, then the seller puts the tax in the jar. The difference between the customer paying the tax, or the seller, is clearly unimportant.

This relies on the idea that prices are determined by supply and demand. In a competitive market economy, such as that in the United States, this is how

prices are determined. Occasionally prices are set some other way, perhaps by government regulation

(e.g., as with a fixed minimum wage, or with regulated prices for utilities or other services), in which case it may well matter who remits the taxes.

And as a practical issue it may well make more sense to have certain parties remit taxes rather than others, since they can do so at lower cost, or can be audited with greater ease.

But note that even these administrative considerations are largely about remittance, not attribution. The social security tax, for example, could be “paid” 75% by employers and 25% by employees without affecting who remits and who keeps records.

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What happens when a tax is imposed?

If the tax is imposed on buyers, the demand curve shifts DOWN.– The demand curve shifts down because if consumers previously wanted 80

units at a price of $20/unit, then, with a $1/unit tax, they will want 80 units at a price of $19/unit.

– This is because the demand curve tells you what people want, not necessarily what they can get.

– Note the implication: the demand curve does NOT shift left, NOR does it shift to the southwest.

If the tax is imposed on sellers, the supply curve shifts UP. If I wanted to sell 300 units at a price of $55/unit, I now want to sell 300 units at $56/unit.

– Example: in a competitive market, the supply curve is the marginal cost curve. Taxes raise the marginal cost of selling a good, thereby raising the supply curve.

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Price pergallon (P)

P1 = $1.50

Quantity in billionsof gallons (Q)

Q1 = 100

A

D

S1

(a) (b)

A

D

S1

S2

CP2 = $1.80

Q2 = 90

$0.50

$2.00

Consumer burden = $0.30

Supplier burden = $0.20

Price pergallon (P)

Quantity in billionsof gallons (Q)

B

P1 = $1.50

Initially, equilibrium entails a price of $1.50 and a quantity of

100 units.

A 50 cent tax shifts the effective

supply curve.

The burden of the tax is split between

consumers and producers

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P2 = $1.30

P1 = $1.50

Q1 = 100Q2 = 90

D1

S

D2

$1.00$0.50

A

B

C

Supplier burden

Consumer burden

Price pergallon (P)

Quantity in billionsof gallons (Q)

Imagine imposing the tax on

demanders rather than suppliers.

The new equilibrium price is $1.30, and the

quantity is 90.

The quantity is identical to the

case when the tax was imposed on

the supplier.

The economic burden of the tax is identical to the previous case.

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OK, so it works.

Principle #1 works because prices are determined by the intersection of demand and supply.

It works even if markets are monopolized, consumers are silly (though they are aware of taxes), or other problems are present, as long as there is unconstrained price determination based on demand and supply.

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Principle #2: People pay taxes.

This principle serves as a reminder that organizations (for example, corporations or cities) do not themselves ultimately shoulder the burden of taxation.

Consider the tax on corporate income. The (considerable) burden of this tax must be borne by one or more of:

– Owners of corporate shares (lower share values, reduced dividends).

– Owners of capital in general (lower rates of return).– Workers (lower wages).– Consumers (higher prices for goods they buy).– Foreigners.– Other people.

When you get right down to it, economics is all about people.

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Principle #3: Inelasticity is expensive.

The burden of a tax is borne by the side of the market (demand or supply) that is less elastic (i.e., less price sensitive).

In an extreme case of perfectly inelastic demand, the burden of the tax is borne by buyers entirely (and not at all by sellers).

In the opposite extreme of perfectly elastic demand, the burden of the tax is borne by sellers entirely. (Note that consumers do not bear the burden of the tax even though they wind up reducing their purchases).

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P2 = $2.00

P1 = $1.50

Q1 = 100

DS1

S2

$0.50

Quantity in billionsof gallons (Q)

Price pergallon (P)

Consumer burdenWith perfectly inelastic demand, consumers bear the full burden.

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P1 = $1.50

Q1 = 100Q2 = 90

D

S1

S2

$0.50

Price pergallon (P)

Quantity in billionsof gallons (Q)

$1.00

Supplier burden

With perfectly elastic demand, producers bear the full burden.

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Why does it work this way?

With inelastic demand, the total quantity does not change after the tax is imposed. Since you have to pay the suppliers a certain amount to get them to sell you this quantity, there is no scope for shifting the burden onto sellers. Hence the burden falls on buyers.

With perfectly elastic demand, the price that consumers face cannot change, since they will simply purchase other substitutes, hence consumers do not bear the burden of the tax.

A similar logic applies to sellers: inelastic supply implies that sellers bear the tax burden, elastic supply that buyers bear the tax burden.

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P1 = $1.50

Q1 = 100

S

D

Quantity in billionsof gallons (Q)

Price pergallon (P)

Hence the price to consumers does not change.

Supply curve does not change when it shifts up.

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D

P

Q

S1

S2

(a) Tax on steel producer

Q1Q2

P1

P2

D

P

Q

S1

S2

(b) Tax on street vendor

Q1Q2

P1

P2

A

B

A

B

Tax

TaxConsumer burden Consumer burden

More inelastic supply, smaller consumer burden.More elastic supply, larger

consumer burden.

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How should one think about these burdens?

When the price rises, and it’s something I buy, then I lose.

Likewise, when the price falls, and it’s something I sell, then I also lose.

But how much do I lose – can we make that more precise?

Well, yes: consumers lose consumer surplus, and sellers lose producer surplus.

The lost consumer plus producer surplus equals the total tax collected plus the deadweight loss produced by the tax.

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Tax incidence in monopolized markets

Works roughly the same way as competitive markets, except that prices are determined by the intersection of MR (marginal revenue) and MC (marginal cost), rather than demand and MC.

As a general matter, the burden of a tax will be borne partly by sellers and partly by buyers.

Depending on the details of demand functions, tax burdens may fall more heavily on sellers in monopoly markets than they do in the case of competitive markets.

– You get a smaller quantity reaction for a given tax, which in turn leads to a smaller effect on consumer price.

– Reflects that monopoly supply is somewhat less responsive to cost than supply in competitive markets.

– For example, if a monopolist has a horizontal MC curve, then the price response to the imposition of a tax is less than one-for-one; if the market were instead competitive, with the same MC curve, the price response to a tax would instead be one-for-one.

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Principle #4: Small things can be big.

This is the principle that a tax may have a very small effect on some market price (such as the price of labor, or the rate of interest), but nonetheless have a very large effect on tax burdens.

Take an example: a tax on business activity in Rhode Island. (Note: Rhode Island is a very small part of a very large country.)

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Business tax in Rhode Island.

Make the following stylized assumptions:– Rhode Island is very small (good assumption!)– All output is produced by a combination of labor and capital.– Labor is immobile: people live their whole lives in the states in

which they are born.– The total amount of capital in the United States is fixed, but capital

is freely mobile between states. Then what happens when we tax businesses in Rhode Island?

The after-tax rate of return to investing in businesses in Rhode Island CANNOT FALL, since if it did, capital owners would just invest in California, Florida, New York, or Texas instead. Hence the owners of Rhode Island businesses DO NOT bear the burden of the Rhode Island tax.

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How does that work?

In order to keep capital in Rhode Island, it must be the case that the pre-tax rate of return to investing there rises when the tax is imposed.

This happens because capital FLEES RHODE ISLAND – and with less capital, the stuff that is left earns higher rates of return.

So who bears the burden of the Rhode Island tax? Workers in Rhode Island! Why?

– Since capital does not bear the burden, workers are what’s left (and workers can’t leave, by assumption).

– With less capital in Rhode Island, labor becomes less productive, and wages fall to reflect that.

– By the way, this is what really happens!

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What about the rest of the country?

The Rhode Island capital goes to California, where it has the effect of…

– Slightly reducing the rate of return to capital in California and the rest of the country (greater supply of capital reduces returns earned by capital), and

– Wages rise slightly in California, since labor there is now more productive due to the added capital.

But…aren’t these effects awfully small? After all, Rhode Island is tiny compared to California, and any effect on the rate of return might be to reduce it from (say) 7% to (say) 6.998%. Yes, except…

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Small things can be big!

The total effect of the Rhode Island tax change on capital returns in California is the product of the change in the rate of return and the total amount of capital in CA. The first is tiny, the second is huge.

Zero times infinity is not necessarily zero. In this case, it can be shown that a Rhode Island

business tax that raises $100m will…– Reduce wages in Rhode Island by $100m.– Reduce the return to capital in the whole United States by $100m. (Why?

Because we started by assuming that the total amount of capital in the United States is fixed. Since U.S. capital is inelastically supplied, capital bears the whole tax burden – though since the amount of capital in Rhode Island is NOT fixed, but instead very elastic, that portion of the capital bears just a tiny tax burden.)

– Increase wages in the whole United States by $100m. (This because the total tax burdens have to sum to $100m.)

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Principle #5: In general, anything can happen.

What this principle means is that, In General Equilibrium, Anything Can Happen.

What is general equilibrium? It is the state of all markets in the economy, not just one at a time. (One at a time is partial equilibrium.)

Why can anything happen? Because in general equilibrium, everything affects everything else, and does so in two ways:

– Through supply.– Through demand.

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General equilibrium reasoning.

In analyzing tax policies (or any other policies) in general equilibrium, it becomes necessary to trace the effects that markets have on each other.

Thus, for example, when a tax imposes a burden on buyers of a good (as would be the case, for example, if the supply of the good is extremely elastic), we then ask what happens to their demands for other goods and services in the economy, and how their prices are affected.

– There can often be significant spillovers into other markets.– Strictly speaking, it is necessary to find the effects of a tax (or other

government policy) on all the prices and incomes in the economy, though in practice, we usually just look for the most important effects.

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Can odd things happen? Well yes.

Consider the case of a tax on ground coffee. (This example is from Vickrey, 1960.) Say that the tax is paid by sellers. This can have the strange effect of actually reducing (!) the consumer price of ground coffee (and also reducing the consumer price of unground coffee beans).

How might that work? Assume: coffee drinkers can buy either ground or bean coffee

from the store, but ground is more convenient. Only problem is that the process of grinding coffee in the store is very inefficient, in that lots of coffee is wasted (falls through cracks in the machine). This makes ground coffee more expensive, though it’s still worth it to many consumers who do not like the messiness of grinding coffee at home. [Assume that consumers do not waste any coffee when they grind it at home, since they are so careful when they do so.]

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Effect of a tax on ground coffee.

When the tax is imposed on ground coffee, it raises the price of ground coffee relative to coffee beans you buy in the store.

Some consumers switch to buying coffee beans instead of the ground stuff.

This reduces TOTAL coffee that stores buy from coffee farmers, since the beans entail less wastage than the ground coffee.

Reduced demand for coffee reduces the prices that stores pay farmers.

This effect on coffee prices (paid to farmers) may be so great that the price of ground coffee ACTUALLY FALLS (and the price of coffee beans falls even more), despite the tax.

The reason: one market affects another.

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Who bears burdens of environmental and other corrective taxes?

Gasoline is heavily taxed, and gasoline taxes have the potential to help correct various environmental, health, and traffic congestion externalities.

Alcohol and tobacco are also heavily taxed. These taxes are imposed in part to raise revenue, but primarily in order to discourage consumption of alcohol and tobacco, which are associated with various social ills, particularly health problems.

One issue that environmentally- and health-friendly tax alternatives raise is the possibility that their burdens fall disproportionately on low- and medium-income families.

If this is true, then this consideration might erode some of the support for green taxes and various health-promoting taxes.

Note that, even if this were true, the government would be able to undo distributional effects by adjusting other taxes (for example, by reducing income tax burdens on low- and medium-income families, but that raises other issues, as a result of which this alternative may be considered not entirely feasible or satisfactory).

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Measuring burdens.

One of the issues in measuring the distribution of tax burdens in practice is how to think about the individuals who bear the burdens.

How would we know whether a particular tax burdens “low income” or “high income” families? We need to know…

– The incidence of the tax: who bears the burden, and how much of the burden they bear.

– Whether those people are rich or poor, middle income, or whatever.

Let’s think about the second of these issues.

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Over what period of time should family income be measured?

There are problems with just looking at one year of income. First problem: fluctuating incomes.

– Incomes go up and down because people have good years and bad years. You could have a bad year and still be generally rich, or a good year and still be generally poor. (In a typical year, the American with the lowest income is one of the wealthiest.)

– As a practical matter, annual income is a highly imperfect measure of average lifetime income due to year-to-year fluctuations.

Second problem: systematic variation over a lifetime.– People tend to have low incomes when young, high incomes when

middle aged, and low incomes when retired.– Is a wealthy retiree poor? Annual income (which is low) would say

he or she is poor, but the retiree may have great purchasing power.

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Does it matter how we measure income?

Yes. The striking thing is how much it matters. The Poterba article on the reading list (“Lifetime incidence and

the distributional burden of excise taxes”) looks at the distributional impact of gasoline, alcohol and tobacco taxes.

In Poterba’s calculations, how one thinks about the distributional consequences of these alternatives turns on the lifetime-annual distinction.

This is not surprising, as lifetime incomes exhibit much less variation than annual incomes: people who are low income may have higher incomes in other years, and those who have high incomes in one year may have lower incomes in others.

Poterba presents a table showing the probabilities of transiting among annual income quintiles between 1971 and 1978:

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Distributional properties of excise taxes.

Consider gasoline taxes first. The ratio of gasoline expenditures to income declines sharply with income (e.g., in 1984, consumers in the lowest income quintile spent 15% of income on gasoline, whereas those in the highest income quintile spent only 2.8% of income on gasoline).

If consumers bear the full burden of gasoline taxes, then this seems to indicate that gasoline taxes are highly regressive, that the burden falls on low-income families.

Poterba notes, however, that annual income may be a misleading measure of lifetime resources. For example, some of the “poor” people in the bottom income quintile are wealthy retirees who drive their heavy cars around all day.

Poterba proposes using total annual consumption expenditures as a measure of lifetime income (which is implied by the permanent income hypothesis). Then looking at the ratio of current gasoline expenditures to total current consumption expenditures offers a very different picture:

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A different way of measuring the distributional of tax burdens.

Gasoline consumption as a fraction of total expenditures differs little among total expenditure (lifetime income) quintiles, other than falling somewhat for the top quintile.

Similar results appear for alcohol, though the income/consumption difference is less pronounced for tobacco.

Note: this makes a big difference! The burden of excise taxes is almost surely not as heavily concentrated on low-lifetime-income groups as the annual consumption/income ratios suggest.

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Why does it make such a big difference?

Recall that there are two primary reasons why annual income differs from lifetime resources (as reflected in annual expenditures):

– Annual income fluctuates due to transitory shocks including unemployment, planned leave from the labor force for education, care of the elderly or very young, income from selling long-held capital assets, bonuses, windfalls, and other sources.

– Incomes fluctuate over the life cycle, with the young and retirees having lower income levels.

Poterba offers evidence that the first of these sources , the annual fluctuations from transitory shocks, is the more important of the two by looking at how expenditure shares on gasoline, alcohol and tobacco vary by age.

– Expenditure shares vary somewhat by age, with those under 25 showing the highest expenditure shares and those over 75 the lowest.

– But these variations are much less pronounced than the expenditure/income ratios in different quintiles, suggesting that age differences alone probably account for a relatively small fraction of the variation.

– Note, too that expenditure/income varies over the life cycle.

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Lessons from this study.

In performing tax incidence calculations, it can make a big difference how one defines income.

By the lifetime resources measure (as reflected in annual consumption), excise taxes, particularly those on gasoline and alcohol, do not look nearly so regressive (falling heavily on those with fewer resources) as they do by annual income measures.

None of this exactly addresses the issue of who actually bears the burden of the excise taxes – these calculations just assume that consumers do, which they may, but only under certain circumstances.

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So who bears the tax burden?

The bottom line is that the burdens of different taxes are borne by different groups. (Oh.)

Most – no, all – of the available calculations of tax burdens are based on simplifying assumptions of dubious validity. The worst of all is the assumption that just because someone remits a tax payment means that they bear the tax burden.

In order to analyze tax burdens it is necessary to apply the five principles.

Globalization of the economy has the potential to change tax incidence, particularly if globalization increases some demand and supply elasticities.

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Consumption taxation.

We have grown accustomed to the notion that governments tax income, but consumption taxation is an alternative.

What makes this alternative popular?– Consumption taxation is generally more efficient than

income taxation, because the deadweight loss of distorting the saving/investing margin is so large.

– Consumption taxation is usually considerably simpler than income taxation.

– Consumption taxes can address externality problems.– Some people believe that fairness dictates that income be

taxed not when earned but when consumed.– Excise taxes can be designed to make users of government

services pay for the services they consume.

The varieties of consumption taxation.

Broad-based consumption taxation, such as general sales taxes or VATs.

(Everybody other than the U.S. has a VAT.) Excise taxes on specific things. An income tax that either does not tax the return to

saving (e.g., Roth IRA), or else permits a deduction for new saving (e.g., traditional IRA).

– This reflects that: Income = Consumption + Saving– Hence: Consumption = Income – Saving.

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Why tax specific items with excise taxes?

To make users pay for government programs related to consumption of specific items.

– Federal tax on bows and arrows, outboard motor fuel, superfund-type taxes. Air transportation tax.

– Taxes on tobacco and alcohol.– Gasoline taxes.

To discourage the taxed activity, if it generates externalities.

– Taxes on tobacco and alcohol.– Taxes on ozone-depleting substances.– Gasoline taxes.

Fact is, the United States makes rather little use of excise taxes compared to other rich countries.

Federal excise taxes used to finance related expenditures

Item Tax rate

Sport fishing equipment 10% of sales price

Electric outboard motors and sonar devices

3% of sales price

Bows and arrows 11-12.4% of sales price

Firearms and ammunition 10 or 11% of sales price

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Excise tax revenues, as % of national income, 2002

Australia 4.5 % Canada 3.2 France 3.6 Germany 3.6 Japan 2.1 United Kingdom 4.3 Europe Average 4.0

United States 1.8

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Excise tax revenues as % of total tax revenues, 2002

Australia 14.3 % Canada 9.5 France 8.1 Germany 10.1 Japan 8.2 United Kingdom 12.0 Europe Average 9.9

United States 6.9

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Other externalities.

Various bad habits that people have.– Smoking.

Accounts for more than 400,000 deaths/year. Externalities from:

– Second-hand smoke.– Reduced workplace productivity.– Causing fires.– Health costs paid by others (out of $75b of annual health costs).

Large positive externalities from reduced retirement benefits. Net external cost (47 cents a pack) is small compared to the cost that smokers

impose on themselves ($35 a pack).– Drinking alcohol

Main external problem is drunk driving ($120b a year in cost). Also creates problems for drinkers, but these are estimated to be smaller.

– Overeating, lack of exercise. Is there a role for public policy in regulating or taxing unwise individual

behavior? Should we think of that as an externality?

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Why tax consumption instead of income?

Consumption taxation is much more efficient.– Consumption taxes do not tax returns to saving and investing.– This is where deadweight losses are the largest.– There is a lump-sum component to a switch to consumption taxation.

Consumption taxation is considerably simpler than income taxation. Certain forms of consumption taxation (e.g., environmental excise

taxes) give the government opportunities to impose Pigouvian taxes on externality-generating activities.

Some consumption taxes can be used to impose heavier tax burdens on people who make heavy use of government services.

Many people think that consumption taxation is more fair than income taxation, since it does not impose a higher tax burden on someone just because they decide to save their money and consume later.

But one must be comfortable with the distributional consequences of consumption taxation. One possibility is to combine consumption taxes with income taxes to achieve the desired distributional result.

But there is a deeper distributional issue associated with the introduction of consumption taxes. The issue is generational.

What to do about the greedy old people?

If the U.S. government were tomorrow to increase consumption taxes, presumably in place of income taxes, older generations alive at the time of the transition would be adversely affected.

The elderly paid income taxes during their working lives, then would have to pay consumption taxes later in life. Reducing income taxes along with increasing consumption taxes will not adequately compensate them.

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The lump sum nature of transiting to a consumption tax.

Switching to consumption taxation affords the government the opportunity to grab some of its revenue in a lump sum fashion. Some folks will have already saved, and their saving can be effectively taxed without affecting their labor supply.

The more revenue the government can get in a lump-sum fashion, the less it needs to get in a distortionary fashion with taxes that discourage income production.

This is part of the reason why consumption taxation typically looks so good on efficiency grounds.56

Probing the efficiency gains.

Compare two policies: using a broad-based, flat-rate consumption tax, and using a flat labor income tax.

Neither imposes a tax on the return to saving, so in the long run they are equivalent.

A consumption tax will, however, look better in any simulation, because switching to a consumption tax entails hitting any savings accumulated prior to the transition with a big lump-sum tax.

The opposite is true of a wage tax, because savers who anticipated future tax burdens will suddenly not face them if the government switches to a wage tax.

The burden of the lump-sum tax is not evenly distributed among members of society: the old bear it disproportionately.57

Burdening the elderly.

Note that switching to a consumption tax does not produce a Pareto improvement, since the young benefit at the expense of the old.

Is it possible to design a consumption tax-oriented reform with features to compensate the elderly? Yes, Auerbach analyzes one, finding that most of the efficiency gains go away.

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Generational accounts

It is possible to keep track of taxes paid by different age cohorts (and transfers they receive from the government).

These are known as “generational accounts,” and were introduced by Alan Auerbach and Larry Kotlikoff.

There are sobering realities revealed by these accounts.

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