Env-Econ 101: Who pays a tax? (Part 1)

Last week, in response to my post on gas taxes, an anonymous commenter asked:

Don't consumers pay 100% of all corporate taxes? Otherwise, where does the money come from?...Are you saying that if the corporation reduces the profit margin, then the corp is paying the tax? and if the corp raises the price, the consumer is paying the tax?

Great question, and one we haven't yet addressed in our Env-Econ 101 series.  So here goes:  If a producer is taxed, who bears the burden of the tax?

In fancy econogeek speak, the question of who bears the burden of tax is known as the incidence of taxation.  Let's keep it simple.  Suppose we have a competitive market for an arbitrary product.  We'll call the product General And/or Specific, or GAS for short.  If the government decides to tax GAS, who pays the tax? 

The figure to the right represents the market for GAS.  From the basics of supply and demand post:

Believing that people buy less at higher prices and that sellers want to sell more at higher prices means that you believe that price and quantity demanded are inversely related and that price and quantity supplied are directly related.  If we put this onto a standard graph with prices on the vertical axis and quantity on the horizontal axis then believing those two statements means we can draw an downward sloping demand curve and an upward sloping supply curve.

The demand curve represents the maximum amount buyers are willing to pay for a given quantity of GAS.  The supply curve represents the minimum amount sellers are willing to accept to sell a given quantity of GAS.  Obviously the price consumers are willing to pay is related to the satisfaction they receive from consuming gas.  Or better put, the price consumers are willing to pay represents the maximum amount of other stuff consumers are willing to give up to consumer GAS--the opportunity cost.  If consumers can get GAS for less than they are willing to pay, then they are happy.  We call this savings 'consumer surplus' because it represents money that buyers can spend elsewhere.

Similarly, the amount sellers are willing to accept to sell GAS must be related to the cost of producing GAS.  If producers can sell GAS for more than the cost of producing it, then they are happy.  We call this 'profit*'.  Profit is just another term for money sellers can spend elsewhere. 

So consumer surplus plus profits give us a measure of money generated by a market that can be spent elsewhere. Why do we care?  Because there exists a unique price quantity combination that maximizes consumer surplus plus profits.  That price/quantity combination is what we call the equilibrium (P*, Q* in the graph) and it occurs when the price buyers are willing to pay exactly equals the amount sellers are willing to accept. 

Now what happens in the market when sellers are taxed a certain amount per gallon sold?  The tax can be viewed as an increase in the cost to the producer or an increase in the minimum amount a producer is willing to accept to sell.  Graphically, this shifts the supply curve up by the amount fo the tax.

In order to recover the increased cost, the seller might try to pass the tax on to the consumer.  But can that happen?  To an extent, yes, but not to the extent we might expect.  If the seller tries to pass the full tax on to the buyer (just raises the price by the amount of the tax), how might the buyer react.  If we believe the law of demand, then buyers will react by buying less--I'm going to leave the question of how much less to part 2.  Suffice it to say that if the seller tries to pass the full tax to the buyer then the sellers profits will fall.  Why?  Because they are receiving the same amount per gallon of GAS sold, but selling fewer gallons.

But falling profits are not necessarily reason for concern.  After all, the tax revenues generate income for someone and the tax may be designed to reduce an external cost of GAS production or consumption.  The real concern comes from the disequilbrium between the amount sellers want to sell and the amount buyers want to buy--and disequilbria generate opportunities for profit.  A disequilibrium means there is money being left on the table.  To bring the market back into equilibrium, the price must fall.  But for the price to fall, the seller must bear some of the burden of the tax (graph).

In other words, because buyers react to higher prices by buying less, the seller is willing to absorb part of the tax.  If not, the sellers profits fall by more than they have to.  So what is the net effect of the tax on sellers? 

1. The price buyers have to pay increases, but not by the full amount of the tax (except for a special case).
2. The price sellers are willing to accept decreases, but not by the full amount of the tax (excpet for a special case).
3. The total amount of GAS sold in the market falls.

The relative price split between buyers and sellers is what we mean by the incidence of the tax.

In part 2 of this post, we will:

• Look at the case of a tax on buyers--hint: it's really not that much different from the tax on sellers.
• Look at what affects the incidence of the tax.  What causes whom to pay what?

*Really it's called  producer surplus, but for our purposes there is really no difference between profit and producer surplus. 

Comments

[robertdfeinman]

When you get to part 2 see if you can include the case where the tax is not borne by the seller (that is a corporate tax), but by the buyer (a sales or excise tax, as on liquor).

Also what happens when the tax is used to subsidize the cost of inputs to the manufacturer? Many could make a case that the current federal gas tax is fed back to the industry to encourage more exploration and production, thus lowering the cost of the feedstock and actually increasing the profit of the seller.

Another way of looking at it is that all taxes are meant to redistribute money in ways the government choses rather than leaving things to the "free" market. Sometimes this is explicit as with "sin" taxes, but other times it seems to be motivated by catering to the interests of powerful economic sectors. This would make all such policy at least partially influenced by views of morality.

[...]

Tim,
Thanx for the excellant explanation.

If we disregard any new gas tax money going to support oil companies or their infrastructure;
and we assume that gas prices are rising at a (sort of) steady and predictable rate due to increasing demand,

is it fairly safe to assume that the gas tax will shift some money to the govt that would have gone to the oil companies as the prices go up?

[Tim Haab]

...

stay tuned for part 2.

[Jonathan]

Tim,

Maybe I need to wait for part 2, but my initial reaction is that this post is contrary to basic econ theory (or, at least, econ 101).

You assume there is a competitive market, but my understanding is that by definition, a competitive market has profits equal to zero. Moreover, the supply line--the line which shows the minimum price a firm is willing to accept for a given quantity--shows the price for which profit equals zero.

In a competitive market, if the firm took any of the burden of a tax--as I understand it--then their profits would become negative, and they aren't willing to do that on the long term. The firm could try to cut costs, but a competitive market also assumes the firm is already at MES--cutting costs isn't possible.

Am I way off base here? Are you talking about an imperfect competition? Am I missing something?

[Chris H]

The proportion of the tax absorbed by the seller is also shared between the owner and the employees, so the fraction actually paid by the owners can end up being small.

Perhaps you could add a case study as a part 3? I remember reading a case study a couple of years ago where the split was 30% customers/60% employees/10% owners. I don't know how representative this study was.

[SC Mike]

Jonathan –
In a competitive market, sellers have different cost structures, buyers have different preferences. That’s why there’s Target and Wal-Mart, Starbucks and Dunkin’ Donuts. If there were no profits over time, sellers would become extinct as Kmart and Sears may soon prove.

As a somewhat related policy point, governments typically overestimate revenue when they increase taxes because taxpayers react by producing less, especially with something like a capital gains tax where the taxpayer can elect to avoid it by not selling the asset.

[malcolm]

The key is the distinction between the short and the long run for competitive markets. If firms
are making zero profit, after the tax they will be making less than a normal return. There will be an exit from the market. As the supply shifts left, the price will rise back to its original value if we have assumed wages don't change. There will be fewer firms and less output which will be "good" for the environment
since there will be less pollution.

[Orgaanic George]

Theory VS application

If there was true competition for energy products then consumers would gravitate to the low cost provider. However we do not have a free market for energy products so the only choice consumers have is to pay higher prices or go without.

As with any model you have to have a realistic baseline not just pure econ theory

[Tim Haab]

George,

Stay tuned for Part 2...I'm going to keep teasing it until I get a chance to write it.

[Jonathan]

SC Mike: According to my understanding basic Econ 101, competitive markets have no product distinction--namely, those companies you mention are not perfectly competitive. Think of a market like rice farming. And, if there were no profits over time, sellers would not become extinct--they'd stay in business because their owners and employees would be making living wages. Moreover, competition forces everyone to be as efficient as possible (MES). In other words, everyone has similar cost structures, at least to the extent that they have similar profits (zero).

A rise in the cost of production (such as a tax) would cause some firms to close down, but there is still no burden of the costs borne by firms (other than a possible social cost, as people have to find new work). Again, if they had to take on any of the cost of the tax, no firm (or, most firms, since competition is never perfect) could not operate.

malcolm: According to my understanding of Econ 101, profits are counted after tax regardless. That's just another aspect of their costs. In competitive markets, there is a normal return after tax, and no exit from markets. After the tax, firms must charge a price such that they still at least break even (a new equilibrium will exist). It'd be ridiculous if they took loses, though some firms would close.

[Jim]

George

At the risk of taking the discussion thread off track:

How is the energy market not free? You have plenty of choices - ride a bus, train, horse, bicycle (I didn't say they were good choices). I hope you mean that there are no real viable choices for the lifestyle to which we are accustomed that don't cost anything more. My flip comment about horses aside, the reality is that petroleum based energy is still the cheapest, otherwise there would be competitors. But we MUST start finding ways to be more efficient. It is the only real way to make a difference at this point.

We (we being the American People) have decided that we don't want to develop our own petroleum (no drilling in ANWR, off East and West Coasts or eastern Gulf of Mexico or in large parts of the Rocky Mountains) but we don't like the cost that comes with that decision (Soldiers in the Middle East and dealing with people like Mr. Chavez in Venezuela along with higher fuel prices). We've made our collective beds and now we get to lie in them (we elected the knuckleheads after all).

The good news is that with higher fuel costs competitors start to develop. But it's hard to be patient. The bad news is the pain in the interim. But we suffered though the shocks in the 70's, we'll get through this one too. But since we don't seem to want new supply, we must reduce demand if we want prices to moderate.

As to the tax discussion, it seems that everyone is assuming the tax is buried in the price, but it isn't really is it? Most merchants (except for Fuels for some reason - ever see the tax broken out on a gasoline receipt?) add the tax as a seperate charge, so psycologically it falls outside of the purchase decision.

[Mike Giberson]

Jonathan, the key point is that it is only the supply of the marginal unit for which profits are zero. Inframarginal profits are possible in the short run. In the long run, whatever factors of production responsible for generating the inframarginal profits capture the rents, a process which in long run equilibrium leaves everyone paid a normal rate of return (i.e. at least as much profits obtainable by shifting factors elsewhere in the economy AKA normal returns AKA zero profits).

Been a while since I was in Econ 101. Hope I got all of that right.

[Jonathan]

Mike, while some firms make a positive profit in competition, my understanding is that others will make negative profit--and the market just clears such that the average firm has normal profits. Which would lead one to believe that on average, firms cannot bear any of the burden of a tax. Discussion of theory (such as this blog post) typically refers to what tends to happen, not the special cases where competitive firms make a profit.

Moreover, in competition, most firms must be near MES in order to survive, so that any firm in the market would be near the margin. If one firm is able to cut costs somehow and be able to make a profit, then other firms would copy the tactic. Therefore, your explanation assumes imperfect information in order to have some firms make a profit, which is contrary to econ 101 theory.

I could be wrong, though. Your explanation is probably more compelling in a realistic sense, and not in a very highly competitive market.

Regardless, your explanation leads to the conclusion that in the long run, taxes are entirely paid for by the consumers (since in the long run, firms receive normal profits). If that's your argument, I could be convinced that firms suffer some of the burden of taxes in the extreme short run--before the market has had time to clear--but that isn't the case in the scenario painted by Tim Haab above.

[John Whitehead]

Tim: I've posted part 1 as a 101 page.

All: I just skimmed the comments but there seems to be confusion between accounting and economic profits. Economic profits subjects unpaid opportunity costs from accounting profits.