Many tax analysts argue that a fourth criterion should be added to the evaluation of any tax: its distribution or “incidence.” All taxes, after all, represent a diversion of some person’s or some business’s income to the government. And according to many analysts, governments often don’t adequately consider who (e.g., the producer or the consumer) ends up paying a particular tax and how this affects the overall economy; that is, they don’t pay enough attention to the incidence, or distribution and burden, of the tax.
Suppose for example, that the federal government responded to news of record oil company profits by imposing a new tax on oil imports and refining capacity – i.e., the producer of the oil. Its proponents might argue that the tax imposed an affordable and fair assessment on a thriving industry. But who would actually pay the tax? The oil companies? Or would they pass the tax, or at least a portion of it, on to consumers by charging more at the pump? The answer depends on the elasticity of demand for gasoline. If higher prices will not reduce the amount of gas purchased, the company will pass the tax on to consumers—in other words, if demand is inelastic, the incidence of the tax will be shifted toward consumers. But if higher prices at the pump will significantly reduce sales, the oil company will be forced to absorb more of the tax themselves—if demand is elastic, the incidence of the tax will remain primarily with the producer.
This makes intuitive sense—but we can plot all this out more precisely using supply and demand curves.
Suppose that the supply and demand curves for gasoline looked like this:
We can see that the equilibrium price for gasoline—where the price consumers are willing to spend, and producers are willing to charge, meet—is $3.25 per gallon. Now let’s add 50¢ to the price of gasoline representing the increased production costs resulting from the introduction of new oil taxes.
Note that the equilibrium price has shifted only a little. This is because gasoline demand, at least in the short term, is inelastic. Therefore, the majority of the new tax will be passed on to consumers.
How elastic is demand for gasoline?
In the short term, gas demand is inelastic. Like other goods with inelastic demand, gas is a necessity. People have to have it so they will continue to buy it even when prices rise.
However, as with many other goods with inelastic demand, demand will become more elastic if high prices persist over time. People will find alternatives and reduce consumption. They will carpool, buy smaller cars, dust off their bicycles, and take public transit.
And the greater the price hike, the faster the adjustment. In May 2008, with gas prices hitting $4 per gallon, Americans drove 9.6 billion fewer miles than they did during May 2007. For the year as a whole, the Federal Highway Commission concluded that Americans drove about 3.6% fewer miles.
If the tax had been imposed on a different good—say, fur coats—that had more elastic demand, its incidence could not be easily shifted to consumers. The supply and demand curves would look like this:
The bottom line is that who pays a tax of this sort is not really determined by who can, should, or was supposed to pay it. Tax incidence is determined by the laws of supply and demand that govern most market decisions, and the details of distribution are shaped by the elasticity of demand for the product taxed. Most commonly, the tax burden is shared by producers and consumers, but the elasticity of demand determines how evenly this burden is shared.
Last but certainly not least, what about the burdens of taxation on the economy as a whole? If we can assume that the economy naturally operates at something approaching full efficiency (and that's a big assumption, but let's roll with it for the moment) then the imposition of any tax on a good that doesn't have completely inelastic demand will introduce economic inefficiencies and cost the overall economy some portion of its potential productivity. In economist-speak, this is because taxes introduce "deadweight loss" – check out the chart below to see how this works:
In this scenario, we've imposed a new tax on the good in question. The supply curve moves up by the amount of the tax, but demand remains the same. The result is that a lower quantity of the good is sold than before. The government gets the area of the yellow box as revenue, but the area of the triangle in the middle is "deadweight loss" – neither producers, nor consumers, nor the government gets anything from this area of lost potential productivity.
Many economists, extrapolating from such examples to the economy as a whole, believe that lowering taxation rates will lead to less deadweight loss and thus faster overall economic growth. But some other economists are a bit more skeptical. Some taxpayer-funded government programs, they argue, have "multiplier effects" that actually increase long-term economic growth. Taxes might pay for useful infrastructure, for example – railroads, highways, communications networks – that would then allow faster growth by private businesses. Similarly, well-designed government investments in the health or education of the population might lead to a smarter, healthier, more productive work force. Government-funded research in basic science and technology can lead to explosive growth in the private sector; the internet, for example, began as a taxpayer-funded government project and then blew up into a huge and dynamic sector of the economy once private businesses started trying to make money off it.
Long story short: taxes impose a real burden upon both the individual people and businesses that pay them, and upon the economy as a whole. If the government spends its tax revenues wisely, then some of those burdens may be offset. If the government wastes its money on ill-advised programs, though… then we've all got plenty to complain about.
Why It Matters Today
Since tax incidence is tied to elasticity of demand, would a direct tax on cigarette companies be passed on to consumers?
Numerous studies have demonstrated that, in general, demand for cigarettes is inelastic, about 0.2. This means that a 10% increase in price causes a 2% decrease in consumption. This would suggest that cigarette companies could pass the bulk of any tax on to its customers without significantly affecting sales. But among teenage smokers, demand is far more elastic; studies place elasticity between .7 and 1.65. This means that among teen smokers a 10% increase in price reduces demand by between 7% and 16.5%. As a result, tobacco companies would lose a portion of their current and, consequently, their future customer base if they did not absorb at least of portion of this tax themselves.
Given the choice of paying taxes or being poor, these guys vote for taxes.
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