ECON 369
Lecture Ten: Tax Analysis – Applications (Statutory and Economic Incidence Analysis)
http://www.taxadmin.org/tax-rates
Excise taxes are moderately important as sources of revenue (at least for the federal government). They are often regressive.
The first part of this analysis is review:
Assume an excise tax of 30 cents per pound of margarine is levied on all sellers in the industry. This means the minimum price at which firms will supply any given quantity of margarine to consumers will be 30 cents higher than before. Thus, the supply curve shifts to the left by 30 cents.
GRAPH - EXCISE TAX
Depends upon the elasticity of demand and the elasticity of supply.
In the above graph, we have drawn both curves with a "normal" slope, showing that some of the tax is paid for by producers and some by consumers.
Why doesn't the producer "shift" the entire tax to the consumer in this case?
GROUP EXERCISE:
Draw the graphs for all four cases (assume curves have a "normal" slope unless otherwise stated):
1. If demand is perfectly inelastic, who will pay the entire tax?
2. If supply is perfectly inelastic, who will pay the entire tax?
3. If demand is perfectly elastic, who will pay the entire tax?
4. If supply is perfectly elastic, who will pay the entire tax?
What can we conclude from this? The more inelastic the demand (with a given supply curve), the more consumers pay. The more inelastic the supply (with a given demand curve), the more producers pay.
What about the Economic Incidence: secondary Effects from the Excise Tax: because markets are interdependent, other markets will be affected by the excise tax. For example, a tax on margarine will increase the price of margarine, thereby leading people to buy more butter (a substitute for margarine).
Graph for Butter:
Shouldn’t We Also Include in the Incidence of the Tax: The “Welfare” Costs of the Excise Tax: In some cases a tax will produce a burden that is larger than necessary to raise a given amount of tax revenue. This additional burden occurs because the tax leads to a misallocation of the resources that remain in the private sector. This welfare cost of taxation is also called the excess burden of taxation, to emphasize that it's a cost in addition to the direct burden as measured by the tax revenue raised.
In the case of the excise tax – the tax drives a wedge between the price that guides consumer decisions and the price (net of tax) that guides producer decisions. We will end up with too low an output of margarine in our example (given elasticity of demand or supply is not perfectly inelastic).
The familiar triangle BAD is considered the welfare loss – caused by the misallocation produced by the excise tax.
Depends Upon Elasticity of Demand: The more elastic the demand curve for the taxed good is, the greater will be the welfare cost of a given per unit tax. This is because consumption will change much more with the tax – causing a larger drop in the efficient amount of output consumed and produced. The same is true with elasticity of supply.
Depends Upon The Tax Rate: The welfare cost will be greater the larger the tax per unit (with given demand and supply curves).
Assuming NO RENT SEEKING OR RENT PROTECTION:
But Wait – That’s Not All – There are Other Sources of “Welfare Cost”:
The “Welfare” Cost Analysis Above Assumes that the Taxpayer’s Loss is just Offset by the Tax Beneficiaries Gain: this is not necessarily true. The subjective loss of one dollar to person A can not be measured and therefore compared to the subjective gain of a dollar to person B.
What about Administrative Costs: Government administrative costs are welfare costs because these costs reduce the usable revenue received by government.
What about Compliance Costs: Individual taxpayers bear significant costs in complying with tax laws. With excise taxes, businesses bear a cost of collecting and paying the government the revenue, even if they shift the entire tax on to the consumer.
http://www.tradingeconomics.com/country-list/corporate-tax-rate
Corporate income taxes are generally described as taxes on the profits of incorporated businesses. This is, of course, using the term profits as accountants would.
The incidence of a corporate income tax is very difficult to determine. First, we assume that corporations are competitive – but the tax falls on all corporations, and some industries are more competitive than others. So the incidence across industries might be different.
Capital can be defined as productive resources, such as factories, machinery, and trucks, etc. This physical capital came about because of investments of financial (money) capital.
The corporate sector employs capital, but so does the non-corporate sector. Depending upon how widely we define capital (including for example an investment in a house or human capital – an investment in an education) our analysis can be very far reaching.
It is usually thought by economists that the non-corporate sector employs half of the capital in the economy (but this is rough estimate depending upon definition).
In competitive markets, the net returns to capital invested in different uses will tend to be equal. Investors will tend to invest capital where it yields the greatest return; if the return is higher in some uses, investors will shift capital to those uses, thus driving down the rate of return until it is equal to the return in alternative uses.
A tax that is placed only on corporate capital will decrease its rate of return relative to non-corporate capital.
Example (assume a "closed" economy):
Assume no tax. Rate of return on both corporate and non-corporate capital is 8%.
Now assume a corporate income tax of 50%.
Short-run: half of the return to corporate investors is taxed away, leaving them with a net return of 4%. The incidence of the tax then falls on corporate investors.
BUT WAIT!
Long-run: The non-corporate rate is still 8% -- so investors have an incentive to shift capital into the non-corporate sector, where it will earn a higher net return. As the supply of capital in the corporate sector goes down, its return increases, and as the supply of capital in the non-corporate sector goes up, its return decreases – until they are the same again. Let’s say at 6%.
In other words, over a period of time more capital in say agriculture and less in automobiles, can occur. Factories and equipment in the auto industry can be allowed to wear out while new investment expands the capital stock in agriculture. There is a reallocation of capital resources.
What does this mean? The gross (before tax) return in capital in the corporate sector is now 12% -- but 6% after taxes. Because the return was 8%, investors are receiving a return 25% less than their earlier return. But this return also affects investors in the untaxed non-corporate sector. Their return is now 6% compared with 8% before the tax.
So – the corporate tax places a burden on all owners of capital, regardless of whether their capital is employed in the corporate sector.
The broader we define capital – the broader the burden falls. People who purchase their own homes might realize a lower return because of the corporation income tax. The same is true for savers, who will earn a lower rate of interest on their savings accounts. Of course, stockholders bear a burden.
Your Reading: Another way of looking at this: domestic vs. foreign capital. Again, if capital can freely flow across borders, the same analysis should apply. Although there are many different factors across countries that impact the rate of return on capital besides a corporate income tax.
Does the incidence fall on consumers?
Because corporations must pay a higher gross return on capital as a result of the tax (to be competitive with the non-corporate sector), the prices of products produced by corporations might rise (depends upon the industry - can they increase prices and remain competitive?) and their consumption will fall. The opposite occurs in the non-corporate sector, output will rise and prices will fall as capital in this sector becomes less expensive.
So will consumers bear a burden of the tax?
There is no reason for the overall or average price of goods and services to be affected. Only consumers who spend a greater than average percentage of their incomes on corporate products will be worse off (if prices do increase in that sector).
Will the incidence fall on workers?
Short Run: Instead of increasing prices (or in addition to) corporations might cut costs in order to pay the higher gross return on capital (net plus the tax). One way of cutting costs could be to cut back on wages and/or benefits. This depends again on the industry (unionized, labor market conditions, etc.). Some workers might move to the non-corporate sector as it expands its capital base.
Some corporate workers then could bear a burden of the tax in the short-to intermediate run.
Long Run: More important is the longer term affects on labor.
As we have discussed, with a lower return on corporate capital - investors move capital elsewhere, then the total amount of capital will fall or grow more slowly over time with the tax then in its absence. A reduction in the amount of capital means that the amount of capital per worker falls so that the marginal productivity of labor and thus wage rates fall (or perhaps grow more slowly over time). Some of the burden is shifted to workers in the form of lower wages.
Again, when bringing in capital flows across borders, the same analysis should apply. If capital flows out of the country -- there is less productivity and over time, this will mean lower wages.
Welfare Cost
In addition to the direct burden of the corporate income tax, it distorts resource allocation in several ways:
1. It leads to a misallocation of a given stock of capital among competing uses in the economy.
2. It leads to a capital stock that is too small (since savings could decrease) and there could be capital outflows (to other countries).
3. It biases investment decisions within the corporate sector. If some assets can de depreciated faster than others, they will be favored (since depreciation is a cost that is considered a legitimate expense that must be subtracted from revenues in determining net income.)
4. It leads to more debt financing and less equity financing (Tullock).
5. It leads to relative price changes (between corporate and non-corporate goods) thereby misallocating resources.
6. It can also bias the labor/capital decision – leading to misallocation this way. Labor might benefit in the short run, but lose in the long run. If capital and labor are substitutable:
Possible Answer?
Have the same marginal tax rate on both corporate and non-corporate capital. This would decrease #1and #5 above but would not take care of #2, #3, #4 or #6. Would also not take care of capital flows across countries.
Application Three: The Incidence of a Payroll Tax
Payroll Tax: taxes that require employers to remit payments based on their total payroll costs. Unemployment insurance, Social Security, Disability, Medicare, Federal Unemployment Tax, Etc.
Because payroll taxes levied on the employer increases the costs of hiring labor.
Assumptions:
Only the employer is required to make payments and that the tax is a fixed amount per labor hour rather than a % of payroll.
Graph: The vertical axis is the wage paid to employees. The horizontal axis is employment. Assume a tax = x is levied on the employers.
Conclusion: employees will probably also bear the burden of at least part of the tax.
What if the labor supply curve is perfectly inelastic? Where would the incidence fall and why?
Graph:
So when congress levies a tax on employers -- they really can't control how much of the tax is paid by them and employees.
DO ICE ELEVEN