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Monday, August 02, 2010

"The Economics of Tax Incidence"

Here is the beginning and end of a post by Stephen Gordon giving a graphical and intuitive explanation of tax incidence:

The economics of tax incidence: paying the tax is not the same as bearing the burden, by Stephen Gordon: ...The statutory incidence of a tax (who sends the cheque to the Receiver-General?) is usually very different from its economic incidence (who is out of pocket?).

The basic intuition is simple enough. We all understand that if the government chooses to impose a tax on gasoline retailers of $0.50 per litre, customers can expect to see a similar increase in gas prices. Even if the statutory incidence falls on the sellers, the economic incidence is borne by the consumers.

The question of who ultimately bears the burden of the tax is almost entirely separate from the question of statutory incidence. ... The key determinant turns out to be the relative elasticities of demand and supply for the the good that is being taxed. ...

Here are two important cases where this distinction has important policy implications:

  1. Corporate taxes. I've gone through this point several times (most recently here) and I've compiled a reading list on the topic over here. If you assume that we are in a small open economy where capital flows freely, the supply of capital is relatively elastic. This corresponds to the first set of graphs, and so the result is that very little of the burden of corporate taxes falls on capitalists. Those who claim that owners of capital bear the entire burden are implicitly assuming - as did Harberger (1962) - that the supply of capital is perfectly inelastic. For large countries such as the US, the supply of capital is less than perfectly elastic, so the applicability of small open economy results can be problematic. But the empirical evidence for small open economies is pretty clear: the burden of corporate taxes falls mainly on workers.
  2. Payroll taxes. These include employer contributions to EI and C/QPP as well as Worker's Compensation premiums. But as a HRCD survey notes, long-run labour demand is more elastic than labour supply, so the ultimate effect of payroll taxes is to reduce wages: "labour's share of the payroll tax burden in the long run is in the range of 87 to 100 percent."
If you're concerned about distributional issues, then this is an important concept. It's a mistake to go from noting that the statutory incidence is on a certain group of people to concluding that these are also the same people who actually pay the tax. Unfortunately, it's also a common mistake.

    Posted by on Monday, August 2, 2010 at 12:15 AM in Economics | Permalink  Comments (31)


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