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?
- The price buyers have to pay increases, but not by the full amount of the tax (except for a special case).
- The price sellers are willing to accept decreases, but not by the full amount of the tax (excpet for a special case).
- 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.