Tax incidence

Matt Nolan rightly notes that tax incidence in general equilibrium after prices have adjusted is far more complicated than just "this guy gets $25 more per week after a tax cut while this guy only gets $0.50" linear estimates from the initial change in tax rates.

That's true, of course, but the problem is bigger.

Matt starts by assuming that folks kinda get the scissors of supply and demand and that relative price elasticity determines tax incidence: statutory incidence is irrelevant. For simplicity, imagine a tax charged on the seller of a good that is perfectly elastic in supply and perfectly inelastic in demand. It currently sells for $5. The government says they'll charge the seller a $1 per unit tax. Voters love it because the sellers are big business, and everybody hates big business. Had it been a tax levied at point of sale on consumers, they'd have wailed and gnashed teeth because that's a tax on the poor customers who buy the goods. Of course, in this example, the price paid by consumers jumps to $6 regardless of whether the statutory incidence falls on consumers or producers. It's relative elasticity that decides who bears the incidence of the tax, not statutory incidence. And the inelastic side of the market bears the burden.

But voters are utterly incompetent at understanding this.

And here's the nicest bit of evidence on it from one of my very favorite experimental economics pieces of all time. Rupert Sausgruber and Jean-Robert Tyran's "Testing the Mill Hypothesis of Fiscal Illusion". I'd pointed to it in this prior post, but buried amongst other things.

Here's the experiment. Put a bunch of folks in a computer lab. Tell them they're buyers of good X. Each of them values good X at different amounts: the experimenter tells each buyer that he'll buy X from them at different prices for different quantities. That generates individual and aggregate demand schedules. Put in a computerized seller with a set supply curve. Let folks run a few rounds of trading with the computerized seller.

Then, let the buyers take a vote on an inefficient redistribution mechanism. If the resolution passes, a tax will be imposed on the buyers, per unit sold. The collected money will be divided evenly among buyers, but with some of it taken off the top as waste. Surprise surprise, nobody much wants that mechanism. Then, reframe it as a tax on the seller. Let them vote again. And, the buyers love it. Never mind that the incidence of the tax is identical across the two treatments. Indeed, in their design, the incidence falls entirely on consumers.

And that's why politicians love to use statutory incidence to frame things for voters. ACC: that's paid for by employer contributions as well as employee. Employees, you don't have to worry about the part your bosses pay. Corporate taxes: who likes companies other than hard-hearted economists? Producer taxes. When Canada shifted from the Manufacturer's Sales Tax to the GST, lots of idiots complained because where companies previously paid the tax, NOW the tax was going to be paid by consumers; Canada wound up with a pretty dirty GST, but still better than the prior manufacturer's sales tax.

In the Tyran and Sausgrubber experiment, voters eventually figured out that they bore the incidence and eventually voted against the inefficient redistribution mechanism. But that's in an experimental setting where the only things changing in the world are whether the scheme is in place or not. Under those conditions, it's pretty easy for the traders to see that the policy makes them worse off. But the real world is noisy, and there are always a hundred other things that voters can blame for the effects of their preferred policy. Indeed, they may wind up arguing that the business was evil for putting prices up when the tax was implemented and that regulations are needed to ensure that the tax works as it was "meant to".

Always ALWAYS beware of taxes that purport to fall on disfavoured groups. The economic incidence may not be what you're hoping it'll be. And that's even before all of the GE complications come in.

I teach this in my third year public choice class at Canterbury. Third year students, almost all of them econ majors. And at least half of them don't understand tax incidence before I show it to them prior to showing the Sausgruber and Tyran result. If folks almost finished an econ major don't get it, there's absolutely no hope in expecting voters to get it. And, of course, politicians well know that only statutory incidence matters to most voters, and so we get the policies we get.