Who Pays the Tax? Theoretical and Empirical Considerations of Tax Incidence

The question of who pays a tax has a discernible answer that need not be shrouded in technical mystery. This paper offers those who have little or no formal exposure to economics a tutorial in the economics of tax incidence. The analysis begins by considering a simple market for butter in a provincial town in France. A tax is placed on butter and its impact on both buyers and sellers is examined. A number of general principles of tax incidence are derived. The paper then examines three taxes used in the United States. Evidence as to the incidence of each tax is presented. The empirical analysis is broadly consistent with the theoretical predictions. The upshot is that a bit of basic economic analysis coupled with some common sense will take the untrained analyst a long way in making reliable predictions as to tax incidence.

Of the 44 states that made budget predictions for fiscal year 2012,  all anticipate budget shortfalls ranging from 2 percent in Indiana to over 45 percent in Nevada.[1]  Moreover, the federal government is currently running a budget deficit estimated to be 8.7 percent of U.S. GDP.[2]

As a result of this fiscal crisis, legislators will likely consider tax increases in future sessions. Such proposals will inevitably be debated, and an important component of these debates will be who bears the burden of the tax increase. Unfortunately, which party ultimately bears the burden of a tax can be a source of much confusion and misstatement. The purpose of this paper is to outline the basic principles of what economists call tax incidence.

A simple way of thinking about tax incidence is to consider the following conceptual exercise. Suppose a $1 tax is imposed on the sale of butter at the retail level and it is the retail outlet’s responsibility to remit the tax revenues to the government. If the price consumers pay for butter rises by a full dollar, then the burden—the incidence of the tax—is fully borne by consumers. In this case, although the retailer incurs the statutory incidence of the tax, it is able to shift forward the full economic incidence of the tax to consumers.

If, on the other hand, the price rises by less than $1, then someone other than the consumer must pay part of the tax. This tax revenue could come from retailers or from someone in the butter supply chain in the form of a reduction in their compensation. The retailer may shift backward part or all of the tax burden to the butter wholesaler, the butter manufacturer, the dairy farmer, or someone else in the production process.

The entity with the obligation to remit the tax revenues to the taxing authority may not be the entity who pays the tax. In other words, the statutory incidence is not necessarily the same as the economic incidence. This observation is important because the general public and policymakers often assume that the statutory incidence and the economic incidence are the same. What determines who pays the tax?

The side of the market with participants least able to adjust to a price change bears most of the tax. This point is the central theme of this essay.

A recent political controversy in Minnesota illustrates the problem. In an attempt to balance the state budget, legislators proposed a package of tax increases that included a surtax on lender income from credit card balances.[3] The proposed legislation would have imposed a tax “at the rate of 30 percent on any income attributable to interest collected from the portion of an annual percentage rate that exceeds 15 percent on [credit card balances and] transactions.”[4] The Minnesota Department of Revenue estimated the tax would yield $118.9 million in the first year.[5]

The bill imposes the statutory burden of the tax on those credit card lenders who charge an annual rate of interest in excess of 15 percent. As most credit card issuers are banks, it seems the bill’s intent is to balance the state budget by delivering a blow to rich banks that gouge poor consumers. Given that the credit card tax is buried in a larger tax package and is accompanied by public pronouncements that it is a tax on banks, the average voter might believe the incidence would indeed fall on banks. But even a cursory appeal to economics reveals a different story.

Suppose the hypothetical XYZ bank charges Minnesotan John Doe a rate of 21 percent on his unpaid credit card balance. Doe has an average annual balance of $10,000, yielding the bank $2,100 in income. Under the bill, the bank pays the state $180 in taxes.6 However, what prevents the bank from simply raising the rate it charges Doe to make up for the tax or from canceling Doe’s credit card? XYZ has many alternatives to lending to Doe. The high interest rate Doe pays indicates he has few alternatives to borrowing from XYZ. Thus, consumers would bear the actual burden of the tax although banks would bear the statutory incidence.

And just who are these credit card consumers? St. Thomas University economist John Spry’s examination of the proposed tax concludes that “Minnesota’s proposed thirty percent surtax on consumer interest in excess of fifteen percent would create a highly regressive tax.”[7] Specifically, “twenty percent of the new tax would be paid.

by Minnesota families with the lowest 10 percent of income. Thirty-seven percent of the tax would be paid by families with the lowest 20 percent of income.”[8]

Minnesota did not adopt the tax. The plan was derailed after a sponsor of the bill stated, “I don’t know what the consequences will be.”[9] Although the poorly designed tax did not inflict damage on Minnesota, the experience offers a cautionary tale: The party who is assessed a tax and the party who actually pays a tax are not necessarily the same. But can it be known before a tax is enacted who will actually bear its incidence? Will the retailer always be able to shift a tax burden forward or backwards? Are there general and readily discernible principles of how tax incidence is apportioned, or are policymakers forced to rely on the esoteric modeling of economic experts?

The answer is that the economic incidence of any given tax is generally knowable. Although the detailed split of the tax may require statistical expertise beyond the scope of most policymakers, some very simple principles and a bit of common sense will take one far down the road in understanding how a tax is likely to play out.

To promote an understanding of these principles, this paper offers a simple example that explains the possible ways tax incidence can be apportioned between market participants and what forces determine the apportionment. We then turn our attention to three taxes that are or have been actually imposed in the United States with an eye to what statistical analysis suggests are the actual patterns of tax incidence. In general, the evidence confirms the principles of tax incidence as valid.

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