One of the most important, and least understood, economic relationships is tax incidence. Policymakers often hold the mistaken belief that when they impose a tax on a particular type of income, the people who create and earn that income are the ones who pay the tax. What they fail to understand is that this is usually not true, because even if someone nominally has a tax imposed on their income, the tax changes behavior and spreads far beyond the people that the policymakers had targeted in their sights.
Some simple examples: If the tax is on the income that comes from selling a particular good, and the demand for that good is inelastic, then the people who buy that good will bear the burden of the tax. Even if the intention was to tax the income of “greedy, evil corporations”, the reality is that the consumers pay the price, because they really want the good and they are not very sensitive to changes in its price. Alternately, if the tax is on income from selling a good for which demand is elastic, the producer will not be able to pass on the tax increase, and the firm will bear most of the burden of the tax (as an aside, when firms face elastic demand, they are often operating on small profit margins, so imposing a tax may lead to firms leaving the market, leading to higher prices and less consumption of that good. How’s that for an unintended consequence?).
In reality the effects are even more subtle and complex. Take, for example, this analysis from the Congressional Budget Office of the incidence of the corporate income tax. The unintended effect that really drives the tax incidence is that at the margin, the corporate income tax induces capital owners to relocate capital outside of the US. Changing the US income tax changes the relative rate of return to capital, inducing some of it to move.
But here’s the real kicker in the unintended effects department. Remember that to a very large degree capital and labor are complements, not substitutes, so more capital means more ability to hire labor and higher productivity of the labor that is hired. Higher productivity means higher wages. When capital leaves, it reverses that effect, reducing worker productivity and lowering wages. Thus the result the CBO finds:
Burdens are measured in a numerical example by substituting factor shares and output shares that are reasonable for the U.S. economy. Given those values, domestic labor bears slightly more than 70 percent of the burden of the corporate income tax. The domestic owners of capital bear slightly more than 30 percent of the burden. Domestic landowners receive a small benefit. At the same time, the foreign owners of capital bear slightly more than 70 percent of the burden, but their burden is exactly offset by the benefits received by foreign workers and landowners.
Thus the incidence of the corporate income tax falls extremely largely on workers. Do you think Congress realizes that the corporate income tax harms precisely the people to whom they demagogue? More importantly, do you think the workers harmed realize this? Or do politicians succeed in using the fog of rhetoric to obfuscate this subtle relationship?
Hat tip to Greg Mankiw for the link to the CBO study.