Understanding Tax

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.

4 Why We Pay Taxes

Taxes are the dues we pay to belong to Club USA. The Club provides enormous benefits to its members – safety, prosperity, freedom, security, community. It charges dues on a sliding scale, based on its members’ ability to pay. April 15 is Dues Day.

Some say taxes are theft. I say that taking Club benefits without paying dues is theft.

Some say they would like to starve the Club to death – “to get it down to the size where we can drown it in the bathtub.” I say that folks who don’t like our Club should join a different one.

I’m tired of paying my Club dues regularly and honestly and listening to freeloaders who shave their taxes run the Club down on talk radio while expecting the Club to bail them out whenever they’re in trouble.

Honest taxpayers are the true silent majority. It’s time for us to speak up.

Freeloaders, pay up or get out.

3 Why Oil Companies Don't Drill

U.S. oil companies are pushing hard to get Congress to allow the current Administration to issue more oil leases before its term expires. In response, skeptics have noted that three-quarters of the 90 million-plus acres of federal land already leased for oil drilling are not being worked. Oil companies deny this. Regardless of who is right, the number of operating oil rigs in North America declined across the course of 2007.

In the meantime, OPEC has raised its quotas by only 20% since 1998 – a measly 2% per year. World GDP grew by about 85% over the same period. The International Energy Agency reports that non-OPEC oil countries are also underproducing and predicts that they will continue to do so.

Everyone seems to be holding back.

Why?

The most likely answer is very simple.

Goldman Sachs has predicted that the price of oil may move past $200/barrel within the next 6 to 24 months. OPEC's chief and EU’s energy commissioner have also both warned that prices in excess of $200/barrel are possible in the near future.

Suppose you owned a source of oil. Would you sell that oil now for $140/barrel? Or would you wait for two years and sell it for $200/barrel?

Obviously, you would wait.

Nor is it clear that oil prices will peak at $200/barrel. If world GDP rises another 85% over the next decade and oil production increases by only 20%, we may come to view $200/barrel oil as dirt cheap.

So what to do?

On the tax side, Congress has done almost all it can do to stimulate U.S. production.

A 2005 Congressional Budget Office study concluded that the effective 2002 U.S. tax rate on profits from petroleum and natural gas structures was the lowest imposed on any type of corporate capital asset: 9.2%. Profits from computers, by contrast, were taxed at an effective rate of 36.9%.

A 2000 study by the Institute on Taxation and Economic Policy concluded that in 1998, of all U.S. industries, petroleum and pipeline companies were taxed at the lowest effective rates: 5.7%. Health care companies, by contrast, were taxed at an effective rate of 32%.

If tax incentives were going to induce U.S. oil companies to drill, they probably would have done so by now. Interestingly, Sen. McCain and Sen. Obama both propose to eliminate oil production tax incentives. After all, if oil companies are not responding by increasing production, those breaks are just gifts from you and me to Exxon.

Perhaps there is another question we should be asking: Are the oil companies right?

Remember that prices are a measure of value. If oil prices are going to be much higher 10 years from now, that means oil will be more valuable then than it is now. Valuable to us.

If so, should it really be our policy to drain U.S. reserves as quickly as possible? Or should our policy be to save at least some of those reserves for the day when gas is $10/gallon?