In a follow up to this post from last year, I want to circle back and actually explain tax incidence and why understanding it will make you a better citizen. Tax incidence is the economic inquiry to answer the question: who actually pays a tax?

Some advocates will argue for higher taxes to pay for greater social services and reduce excessive business profits. Yet many businesses will often tell you that they don’t actually pay taxes. Instead, the businesses argue, that all taxes get passed on to the consumer in the form of higher prices to cover the costs of the tax. It turns out, neither answser is 100% correct.

Let’s say I impose a $1 tax on widgets, levied by requiring all widget manufacturers to pay $1 for each widget they produce. The manufacturer would love to increase its widget price by $1, thereby keeping its revenue at exactly the same level as before. And while it is true that the manufacturer’s per unti revenue will be the same, it still might see its overall revenue fall. Why? Because for some consumers, the extra $1 cost will make the widget too expensive, so they won’t buy it. If sales fall off too much, then the widget manufacturer might lose more money than if it instead eats some of the cost out of its own revenue (and thus profit) by raising the price by less than a dollar. Thus, in order to maximize its total revenue, the manufacture will likely have to share some of the cost of the tax with the consumers.

What if I instead collects the tax by an excise tax? (An excise tax is a type of sales tax levied against only a specific item. Like a general sales tax, it is collected at the point of sale by the retailer.) Here you might think that the consumer will pay 100% of the cost of the tax, as the manufacturer never sees the tax. However, from the consumer’s perspective, the price is effectively the same whether there is an excise tax of $1 added in the store or whether the manufacturer raises its price by $1 before sending it off to the retailer. So, again, the effect is the same on the manufacturer in terms of drop-off of sales. Thus, in order to maintain its revenue, the manufacturer will again have to eat some of the tax by lowering its prices a little, despite the fact that the manufacturer is never directly involved in the collection of the tax.

So how can we figure out who will pay more of a tax? The answer lies in a concept called price elasticity. I won’t explain how to calculate price elasticity, continuing my policy of minimal math, but you can watch some videos here for a longer tutorial .

Essentially, price elasticity is how sensitive demand or supply is to price. Take for example gasoline or cigarettes. Even though the price may go up and up, consumers will still buy these goods in roughly the same amounts. Why? Because there aren’t any real substitutes for these goods, so if you have a car or are addicted to cigarettes, you will need to buy these goods. Economists say such goods are price inelastic, which is jargon for saying that the quantity demanded doesn’t move much despite changes in prices. Your electric utility is another example of an inelesatic good, since it’s tough to live in a modern home without electricity. On the other hand, if, say, ramen noodles were to go significantly up in price, there would be a huge reduction in the quantity of ramen sold, because there are lots of other cheap foods that college students can eat instead. So elasticity is all about substitutes and whether the consumer needs to buy the good or merely wants to buy the good.

What does this tell us about tax incidence? Well, whether the manufacturer or the consumer pays more of the tax depends on how elastic their demand or supply. So, if the government increases taxes on gas or cigarettes, the consumeer will pay basically 100% of the tax because there aren’t good substitutes for those goods and the manufacturer knows it. Since you need to buy gas to run your car, you will pay the higher prices at the pump. However, tax something price eleastic like ramen, and the price will not go up by very much. Otherwise, consumers will just stop buying the good altogether.

What about payroll and income taxes? After all, these aren’t levied on goods. True. They are levied on services, in this case the provision of labor, but the analysis is the same. For most companies, there is no good substitute for labor, at least in the short term. Likewise, for most workers, there is no substitute for actually working, since you’re trying to earn an income. Thus, it turns out, these taxes are paid about 50/50 between employers and employees.

So here’s why you should care: Every year, governments, both state and local, have debates about what and how to tax. If government is going to raise taxes, you (as a consumer) want them to raise them on elastic goods, since that won’t much affect the prices you see. Alternatively, if the government wants to lower taxes, you want them to lower taxes on inelastic goods, like gas or payroll taxes, so you can reap the maximum benefits.

I realize this post was long, but I hope it has made you a smarter citizen and consumer of government. As School House Rock use to tell me every Saturday morning, knowledge is power. Next time, I promise to return to more mundane topics like the happenings at the Fed. As always, feedback is appreciated and encouraged through the comments.