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Public Finance: The Economics of Taxation
(Part C)
by
Charles Lamson
Tax Incidence: Who Pays?
When a government levies a tax, it writes a law assigning responsibilities for payment to specific people or specific organizations. To understand a tax, we must look beyond those named in the law as the initial taxpayers. First, remember the principle of tax analysis: The burden of a tax is ultimately borne by individuals or households; institutions have no real tax paying capacity. Second, the burden of a tax is not always borne by those initially responsible for paying it. Directly, or indirectly, tax burdens are often shifted to others. When we speak of the incidence of a tax, we are referring to the ultimate distribution of its burden. The simultaneous reactions of many households and/or firms to the presence of a tax may cause relative prices to change, and price changes affect households' well-being. Households may feel the impact of a tax on the sources side or on the uses side of the income equation. (We use the term income equation because the amount of income from all sources must be exactly equal to the amount of income allocated to all uses including saving in a given period.) On the sources side, a household is hurt if the net wages or profits that it receives fall; on the uses side, a household is hurt if the prices of the things that it buys rise. If your wages remain the same but the price of every item that you buy doubles, you are in the same position you would have been in if your wages had been cut by 50 percent and prices hadn't changed. In short:   Tax shifting takes place when households can alter their behavior and do something to avoid paying a tax. This is easily accomplished when only certain items are singled out for taxation. Suppose a heavy tax were levied on bananas. Initially the tax would make the price of bananas much higher, but there are many potential substitutes for bananas. Consumers can avoid the tax by not buying bananas, and that is what many will do. But, as demand drops, the market price of bananas falls and banana growers lose money. The tax shifts from consumers to the growers, at least in the short run. A tax such as the retail sales tax, which is levied at the same rate on all consumer goods, is harder to avoid. The only thing consumers can do to avoid such a tax is to consume less of everything. If consumers do, saving will increase, but otherwise there are few opportunities for tax avoidance and therefore for tax shifting. Broad-based taxes are less likely to be shifted and more likely to "stick" where they are levied than "partial taxes" are. The Incidence of Payroll Taxes In 2019, 36 percent of federal revenues came from social insurance taxes, also called "payroll taxes" (taxpolicycenter.org, Federal Budget and Economy). The revenues from payroll taxes go to support Social Security, unemployment compensation, and other health and disability benefits for workers. (These are discussed in part 85.) Some of these taxes are levied on employers as a percentage of payroll, and some are levied on workers as a percentage of wages or salaries earned.  To analyze the payroll tax, let us take a tax levied on employers and sketch the reactions likely to follow. When the tax is first levied, firms find that the price of labor is higher. Firms may react in two ways. First, they may substitute capital for the now more expensive labor. Second, higher costs and lower profits may lead to a cut in production. Both reactions mean a lower demand for the labor. Lower demand for labor reduces wages, and part of the tax is thus a lower demand for labor. Lower demand for labor reduces wages, and part of the tax is thus passed on (or shifted to) the workers, who end up earning less. The extent to which the tax is shifted to workers depends on how workers can react to the lower wages. We can develop a more formal analysis of this situation with a picture of the market before the tax is levied. Figure 2 shows equilibrium in a hypothetical labor market with no payroll tax. Before we proceed, we should review the factors that determine the shapes of the supply and demand curves.  Labor Supply and Labor Demand Curves in Perfect Competition: A Review Recall that the demand for labor in perfectly competitive markets depends on its productivity. As you saw in part 50, a perfectly competitive, profit-maximizing firm will hire labor up to the point at which the market wage is equal to labor's marginal revenue product. The shape of the demand curve for labor shows how responsive firms are to changes in wages. Recall from parts 29 and 46 that household behavior and, thus, the shape of the labor supply curve depends on the relative strengths of income and substitution effects. The labor supply curve represents the reaction of workers to changes in the wage rate. Household behavior depends on the after-tax wage that they actually take home per hour of work. In contrast, labor demand is a function of the full amount that firms must pay per unit of labor, an amount that may include a tax if it is levied directly on payroll, as it is in our example. Such a tax, when present, drives a "wedge" between the price of labor that firms face and take-home wages.       The relative sizes of the firms' share and the workers share of the total tax burden depend on the shapes of the demand and supply curves. Figure 4, parts a. and b., shows that the ultimate burden of a payroll tax depends, at least in part, on the elasticity of labor supply. If labor supply is very elastic, that is to say, responsive to price, take-home wages do not fall very much, and workers bear only a small portion of the tax. But if labor supply is inelastic, or unresponsive to price, most of the burden is borne by workers.  Workers bear the bulk of the burden of a payroll tax if labor supply is relatively inelastic, and firms bear the bulk of the burden of a payroll tax if labor supply is relatively inelastic. Empirical studies of labor supply behavior in the United States suggest that for most of the work force, the elasticity of labor supply is close to 0 (Case & Fair, 2004). Therefore: most of the payroll tax in the United States is probably borne by workers.   Some economists dispute the conclusion that the payroll tax is borne entirely by wage earners. Even if labor supply is inelastic, some wages are set in the process of collective bargaining between unions and large firms. If the payroll tax results in a higher gross wage in the bargaining process, firms may find themselves faced with higher costs. Higher costs either reduce profits to owners or are passed on to consumers in the form of higher product prices. *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 360-364* end |
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