Taxes

Who really pays taxes, and why should you care?

/ Edward Thater / Leave a comment

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.

Why No Hate for Job-Killing Advertising?

/ Edward Thater / Leave a comment

As the various branches of the federal government continue to struggle to find ways to put the nation’s fiscal house in better order, a key component of these discussions is whether and how to make tax reforms. If you spend more than five minutes watching Sunday morning news, you know that some policymakers are pretty insistent that taxes cannot be raised because taxes “kill jobs.” My response to this is, “So what?” A lot of economic actions “kill jobs,” many to a larger degree than taxes do, but no policymakers are looking to ban those actions as bad for the economy.

Now, don’t misconstrue me here, dear readers. I am all in favor of tax reform. I think our federal taxation system is too complicated, has far too high a level of compliance costs, and is otherwise a pretty bad way to go about raising government revenue. However, unless and until there is a political consensus about where and how much to cut government spending, there is a legitimate case to be made (one that you don’t necessarily need to agree with) for increasing our current tax revenue to cover more of the costs of government so that we can borrow less. (As an aside, the debate around government spending is usually off base as well. The question should almost never be “how much should we spend?” but rather “are we spending the correct amount of money on the correct things?” But that is a topic for a different blog post.)

It is quite well established that taxes reduce production and reduce jobs. Let’s say the government imposes a $10 tax on widgets. Let’s also say that for the purpose of this example, the market conditions are such that the price of widgets rises by $5. This means that consumers bear half of the cost of the tax through higher prices, while producers bear half the cost of the tax through a hit to their bottom lines. (A fuller discussion of tax incidence and why producers can’t simply pass on 100% of the tax’s cost to their consumers is beyond the scope of this particular post.) However, this means some consumers will be priced out of the widget market, as they will be unwilling and/or unable to pay the new, higher price. Likewise, facing diminished demand and the hit to their bottom lines, producers will scale back production or leave the widget business entirely. That means fewer people employed making widgets. Economists call this loss of economic activity (fewer people buying widgets and fewer producers making widgets) deadweight loss, and it does translate to fewer jobs on an economy-wide scale.

However, lots of other things cause deadweight loss besides taxes. Take, for example, monopolies. The reason monopolies are generally considered bad is because they maximize their profits by creating artificial shortages. This in turn creates a rise in the price per unit (shortage of supply drives prices up), which increases the monopoly’s profits. The monopoly could create more units and sell them at a lower price to people who want the units while still turning a profit, but it wouldn’t be as big of a profit as the one it gets from its artificial shortage. Thus, unchecked market power, which is the ability to control the market price by controlling the quantity produced, creates deadweight loss.

While monopoly is one extreme example of market power, millions of firms in the U.S. economy enjoy some level of market power that allows them to withhold production in order to increase profits. And what causes these firms to have this market power they exercise? For most of them, it is simple advertising.

Companies advertise to build their “market share” by attracting new customers and by building brand loyalty. This, in turn, leads to those businesses commanding a portion of their markets, which allows them to withhold production and make more money. If you’ve ever known someone who rushed to the store to buy the latest Disney DVD release before it goes “back into the vault,” you’ve seen this technique in action. But it’s not just Disney. Firms of all sizes use similar techniques to make more money.

So why aren’t any politicians railing against job-killing advertising? After all, given the millions of firms with some level of market power, the number of lost jobs to advertising is at least as big, if not bigger, than the number of jobs lost to taxes. The obvious political answers are that (a) few policymakers in D.C. have had any sort of economics training, and (b) business hate taxes, which hurts their balance sheets, but love advertising, which pads their balance sheets at the expense of their competitors, so they tend to lobby against the one and not the other.

There are many good reasons to support a smarter tax system with lower rates and a broader base. Such a system would cause less deadweight loss and be better for the economy in the long run. But unless you’re willing to go the extra step to crusade against any economic activity that causes deadweight loss, you should find a better argument to lower taxes.

The Ivory Tower Half Hour: Detroit’s Bankruptcy and Syracuse’s Murder Rate

/ Matthew Clemente / Leave a comment

The Ivory Tower Half Hour: Detroit’s Bankruptcy and Syracuse’s Murder Rate

 

Hosted by David Rubin, Dean of the Newhouse School of Public Communications at Syracuse University, this powerhouse panel of Bob Spitzer (SUNY Cortland), Tim Byrnes (Colgate University), Bob Greene (Cazenovia College), Tara Ross (Onondaga County Community College), and Kristi Andersen (Syracuse University) discuss the new face of the Detroit’s bankruptcy and Syracuse’s murder rate (although unfortunately the panel does not discuss Syracuse Truce).

Here is a description of the program:

 The panelists examine the challenge of bankruptcy facing Detroit—and perhaps Syracuse at some point down the road. They debate who was responsible for the fiscal problems and how best to dig out. Then the panelists offer advice to the Syracuse Chief of Police and the Mayor on how to combat the murder rate in the city, which is the highest for any city in the state.

 

This video runs approximately 27 minutes.

 

Suboxone: Why Government is Frustrating

/ Matthew Clemente / Leave a comment

NPR’s Planet Money team tells the story of Suboxone, an anti-addiction drug that the government subsidized then regulated to the point that it is almost impossible for addicts to access.  To attain the anti-drug, addicts are left turning to… their drug dealers. 

Here is a description of the story: 

There’s a pill called Suboxone that treats addiction to heroin and pain pills like oxycontin. Doctors and addicts say it’s amazing.

“It was the best thing that ever happened,” one heroin addict told us. “I was like OH. MY. LORD. This is a miracle pill.”

The government spent tens of millions of dollars developing Suboxone. Doctors can prescribe it in their offices. But a lot of people who want it can’t get it from a doctor, so they have to buy it on the street.

Today on the show: Why people have to turn to drug dealers to get a pill that fights addiction.