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Econonomic Report of the President, 2004
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http://a257.g.akamaitech.net/7/257/2422/09feb20040900/www.gpoaccess.gov/usbudget/fy05/pdf/2004_erp.pdf Chapter 4, page 106- Theory of Tax Incidence One crucial finding in the study of tax incidence is that the economic incidence of a tax (the identity of the person who bears the burden of the tax) can be completely different from its statutory or legal incidence (the identity of the person upon whom the law officially imposes the tax). In other words, the person who is legally responsible for paying the tax may not be the one who actually bears the burden of the tax. As explained below, the incidence of a tax depends upon the law of supply and demand, not the laws of Congress. Another crucial principle is that only people can pay taxes. Businesses and other artificial entities cannot pay taxes. Although the corporate income tax is legally imposed on firms that are organized as corporations, the actual burden of the tax can fall only on people—perhaps the firm’s owners, or its employees, or its customers—but certainly not on a legal artifact such as a corporation. Similarly, although the estate tax is legally imposed on the estate, the burden of the tax can fall only on people—perhaps the decedent who left the estate, perhaps the heirs, perhaps other people—but not the estate, which is merely a legal construct established to sort through the ownership of the decedent’s assets. It is simplest to first discuss the incidence of a simple excise tax, a tax levied on a specific good or service. As explained below, the key insights from this analysis can be extended to apply to other types of taxes. Incidence of an Excise Tax
Consider a tax on apples. Suppose that when there is no tax, the price of apples is $1. Now, suppose that the government imposes a 10-cent excise tax on apples and that the producers are legally responsible for paying this tax. Do producers actually bear the economic burden of the tax? The answer depends on what happens to the price of apples. If the price remains unchanged, producers bear the economic burden (the economic incidence of the tax is the same as the legal incidence). Consumers pay $1, the same as before, and suffer no burden. Producers, after collecting $1 from the consumers, must pay 10 cents to the government, so they clear only 90 cents. Alternatively, if the price rises by the amount of the tax, from $1 to $1.10, consumers bear the burden. Although they do not send any money to the government, they pay 10 cents more per apple than they did without the tax. The producers bear no economic burden, even though they are legally responsible for paying the tax. After collecting $1.10 from consumers and sending 10 cents to the government, they still clear $1, as they did without the tax. In this case, economists say that the producers shift the burden of the tax to consumers. To consider another possibility, if the price of apples rises by 5 cents, to $1.05, consumers and producers share the burden equally. Consumers bear a 5-cent burden because they pay $1.05 for each apple, compared to the $1 that they paid without the tax. Producers bear a 5-cent burden because they clear only 95 cents per apple, compared to the $1 they cleared without the tax: they collect $1.05 from consumers, but send 10 cents to the government. As these examples show, the division of the tax burden between consumers and producers depends on what happens to the price of apples. When prices are free to adjust, they are likely to be determined by the law of supply and demand. If the price of apples was $1 with no tax, then the number of apples consumers wanted to buy at that price must have equaled the number of apples that producers wanted to sell at that price. What happens when the 10-cent excise tax is imposed? It depends on how responsive consumers and producers are to changes in the prices they pay or receive. The relevant questions are: How many fewer apples do producers sell if the amount they clear per apple declines? How many fewer apples do consumers buy if the amount they pay per apple rises? For example, suppose that producers are four times more responsive to price changes than consumers. Then, producers face a price change that is one-fourth as large as that faced by consumers. The 10-cent tax causes the price to rise from $1 to $1.08, putting an 8-cent burden on consumers and a 2-cent burden on producers. At that price, the number of apples consumers want to buy falls by the same amount as the number that producers want to sell. Alternatively, if consumers were four times more responsive than producers, then producers would bear 8 cents of the burden and consumers would bear only 2 cents. The group that is less responsive bears more of the burden of the tax. The group that is more responsive escapes much of the burden because it responds to the tax, abandoning the taxed activity when threatened with a tax burden. The price-responsiveness of each group depends upon its flexibility. Do producers have good alternatives (in the form of other industries in which they can produce)? Do consumers have good alternatives (in the form of other products they can buy)? The answers vary across products, types of producers (such as workers and owners of capital), and time frames. If the excise tax applied only to Granny Smith apples, consumers could switch to other, untaxed, kinds of apples. If it applied to all apples, consumers would have somewhat less flexibility. Some workers may have skills specific to the apple industry. Other workers may be more flexible because their skills are more general; they could avoid bearing the tax burden by finding a job in another industry. The owners of capital employed in a taxed industry may bear a significant short-run burden because the buildings and equipment in the industry may be designed specifically for its use and the owners may have little ability to move those resources elsewhere. In the long run, though, capital can leave the taxed industry: as buildings and equipment depreciate in the taxed industry, new buildings and equipment are constructed in other industries. A similar logic applies if the product is subsidized rather than taxed. The group that is more responsive receives the smaller benefit because the subsidy prompts new members of that group to enter the market and compete away the benefits of the subsidy. Conversely, the group that is less responsive receives the greater benefit from the subsidy because little entry occurs. Because the incidence of an excise tax depends upon the relative flexibility of consumers and producers, the burden may not always fall where the Congress intends. When the Congress imposed a “luxury” tax on yachts in 1991, for example, it intended the wealthy purchasers of yachts to bear the burden. Such purchasers, however, may be quite responsive to price because there are many alternative goods that they can purchase (expensive cars and jewelry, for example). If this is so, then a significant part of the burden of a yacht tax may fall on workers in the industry, who may be less well-off than owners of yachts. Indeed, after the tax was introduced, production and employment in the boat industry fell, leading some observers to claim that workers were bearing much of the burden of the tax. Although the validity of this claim cannot be conclusively determined (the industry’s decline may have been caused by the 1990-1991 recession rather than the tax), the Congress responded to these concerns by repealing the tax in 1993.
Legal Incidence Is Unimportant
As long as prices can freely adjust, the economic incidence of a tax does not depend on the legal incidence. Suppose that, in the above example, the government imposes the 10-cent excise tax on apple consumers rather than apple producers. Consumers then must make the tax payment to the government, in addition to the price they pay to producers. Because producers are four times more price-responsive than consumers, the price received by producers must still fall by 2 cents and the price paid by consumers must still rise by 8 cents. Despite the legislative change, that is still the only outcome that keeps the number of apples producers want to sell equal to the number that consumers want to buy. If the tax is legally imposed on producers, they shift 8 cents of the burden to consumers. If it is legally imposed on consumers, they shift 2 cents of the burden to producers. Given that the price can freely adjust, it should not be surprising that the final outcome is unchanged. It is irrelevant whether the tax collector stands next to consumers and takes 10 cents from them when they buy an apple or stands next to producers and takes 10 cents from them when they sell an apple. It does not matter whether the consumer puts a dime in a bowl marked “taxes” or hands the dime to the producer who puts it in the same bowl.
Applied Distributional Analysis of Excise Taxes and Subsidies
The legal incidence of Federal excise taxes is sometimes placed on consumers, sometimes on manufacturers, and sometimes on other producers or importers. In most cases, this legal incidence rightly receives little attention. In accordance with the economic theory of tax incidence, the JCT and Treasury economists preparing distributional tables uniformly ignore the legal incidence of conventional excise taxes. The JCT generally allocates excise tax burdens to consumers. Treasury follows a similar, but more elaborate, approach. These approaches are reasonable, since consumers are likely to bear much of the long-run burden of most excise taxes. In the long run, most producers are flexible, or price-responsive, because they can switch to other industries. Consumers are likely to have less flexibility, except in special cases where there are good substitutes for the product being taxed. The theory of incidence also applies to more-subtle excise subsidies, such as those included within the individual income tax. The income tax law grants tax reductions for purchasers of various products—for example, an itemized deduction for medical expenses, a credit for electric cars, and the Hope and Lifetime Learning credits for the costs of higher education. The economic benefits of these provisions are likely to be divided between consumers and producers, with the greater benefit going to the group that is less price-responsive. The long-run benefits are likely to go largely to consumers, because they are likely to be less price-responsive than producers. Official distributional analyses generally allocate these income tax reduc-tions to the consumers. The basic insight that tax burdens fall more heavily on groups that are less flexible can be applied to a wide range of taxes. The remainder of this chapter applies this framework to payroll taxes, taxes on capital, and estate and gift taxes.
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