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.