5 Who Pays Taxes: The Concept of "Incidence," Part I

One of the least understood but most important concepts in tax is “incidence.”

If we impose a tax on A, it may be that A can pass the cost on to B. B may then be able to pass that cost on the C. And C may not be able to pass it on to anyone else. If so, we say that the “incidence” of the tax falls on C.

What this means is that A, nominally subject to the tax, may not ultimately bear the burden of the tax at all.

In 1990, for example, Congress enacted a 10% tax on luxury items – luxury cars, yachts, private planes, jewelry, and furs. The idea was to tax the “rich” without increasing top income tax rates.

What happened instead was that demand for items subject to the tax – yachts, for example – went down. To continue selling yachts, therefore, yachtmakers had to cut prices. In other words, they had to eat the tax. Yachtmakers, in turn, responded by cutting wages. It turned out that luxury yachts were generally made in small towns without employment alternatives. So when yachtmakers cut wages, workers had no other place to go. They had to accept the pay cuts.

Bottom line: the cost of this so-called “luxury” tax ended up being borne primarily by low-income workers.

The incidence of a tax depends on the alternatives the various players have. The player with the fewest choices generally bears the incidence of the tax.

The “rich,” it turns out, can do without yachts. Yachtmakers, on the other hand, cannot do without customers. And yachtmakers’ workers have no choices at all.

This is why taxes on individual income make at least some sense. If an income tax is well-structured (admittedly a big if), to avoid the tax you have to do without income. Most folks like income. And therefore most folks end up bearing the share of the income tax nominally imposed on them. They generally can’t pass it on to someone else.

(This is not always true of businesses, but that’s a topic that merits its own discussion.)

In my next post, I will apply the concept of incidence to other types of government action – tax “cuts,” for example. It turns out that a tax “cut” for A may create costs for B. In effect, B bears the cost of the tax “cut.” From a devious politician’s perspective, the wonderful thing is that B has no clue. From an honest politician’s perspective, the problem is that Congress often has no clue either.

Comments

[Kat]

Professor, the yachtmakers may have received unemployment benefits, derived from my remittals to the fisc. The benefits went right back into the commerce stream paying for the goods and the taxes levied on every transaction. Possibly, the dollars yachmakers spent on food ended back in their pocket through the tax collection streams. In turn, I was taxed to provide the benefits to the yachtmakers - bearing the burden. Because of income tax, I am expecting my employer to pay me more, and the employer, in turn charges the customers more. It seems that the cycle touches everyone: Where is the incidence? What am I missing?

[Theodore Seto]

Kat,

Your question is very perceptive. To find the answer, we need to focus on why we undertake incidence analysis in the first place. Incidence analysis is used by government to assess the unintended effects of its actions. This implies that we should at least pause in our analysis whenever we bump into another government decision point.

In the case of the luxury tax, for example, we might trace the effects of the tax down to the level of the workers in the yacht yards. Whether to continue to give them unemployment benefits is a separate decision, itself subject to incidence analysis. So we can usefully stop at that point and ask whether we really think the luxury tax is doing what we want it to do.

If the answer is No, we may want to repeal the tax (which is what Congress actually did). Either way, we have the option of continuing our analysis along the lines you suggest.

In the case of the luxury tax, the whole purpose was to tax the "rich" without raising rates. Once it became apparent that the tax wasn't going to accomplish that purpose, there was no point in tracing the effects of the tax any further.

[Eric]

Professor,
While incidence is an essential aspect of tax analysis, we cannot forget that all taxes have a net social cost. In econospeak, taxes create a "dead weight loss." Thus, it's not just a matter of figuring out who pays the tax, but the overall impact on society. In other words, incidence is only part of the story. It may well be that a tax won't get "paid" by anyone because it completely stifled the market in that area.

Taxes, as you point out, may prevent yachts from being produced at all. Both yacht consumers, and yacht producers, are harmed by such a tax.

But that's not the end of the story, either. While taxes cause a host of problems, one that is ofter overlooked is that taxes shift production and consumption patterns. Whereas before the tax, market prices directed resources according to consumer preferences--leading to optimal use of scarce resources--the imposition of a tax channels resources to other areas. When resources are diverted from their best use, based on consumer preferences, society as a whole loses because scarce resources are used less efficiently.

[Theodore Seto]

Eric,

I agree with everything you say. Incidence is only part of the story, and not always the most important part. It is, however, one of the least understood -- which is why I'm writing about it.