Economic Incidence and How Much the Rich Pay in Taxes

On December 18, 2007, Alex Tabarrok of Marginal Revolution discussed statistics released by the Congressional Budget Office by stating:

"Despite all the deductions, loopholes and clever accountants the federal income tax is strongly progressive. Moreover the federal tax system remains progressive even if you include the payroll tax, corporate taxes and excise taxes. The chart below with data from the Congressional Budget Office, shows the effective tax rate by income class from all federal taxes. Effective tax rates are considerably higher on the rich than the poor.

"The effective tax rate is higher on the rich and the rich have more money – put these two things together and we can calculate who pays for the federal government. The final column in the table shows the share of the 2.4 trillion in federal tax revenues that is paid for by each income category. The remarkable finding is that the rich and especially the very rich bear by far the largest share of the federal tax liability. The top 10% of households by income, for example, pay more than half of all federal taxes and the top 1% alone pay over a quarter of all federal taxes."

The statistics are correct (at least I assume they are), but they are misleading because of the difference between the legal incidence of taxation and the economic incidence of taxation

What do we mean by economic incidence

The Tax Foundation does an excellent job of describing economic incidence and how it differs from legal incidence. They write:

"Legal incidence is established by law when new taxes are enacted, and specifies which individuals or companies must physically remit tax payments to state and local treasuries.

"The legal incidence of taxes is generally very different from their final economic burden. Because taxes influence the relative prices facing individuals, they lead to changes in individual behavior. These tax-induced changes in behavior cause some portion of the economic burden of taxes to be shifted from those bearing the legal incidence onto others in society. For example, the legal incidence of local retail sales taxes typically falls on companies. But economists agree that some portion of these taxes is shifted forward to others, in the form of higher prices to consumers, lower wages to workers, reduced returns to corporate shareholders or some combination of the three.

"This tax-shifting behavior often causes the economic burden of taxes to differ dramatically from the legal incidence. Once these tax-induced changes in behavior throughout the economy are accounted for, the final distribution of the economic burden of taxes is called the economic incidence. Economists refer to measures of this economic incidence as the tax burden faced by individuals."

Although governments may claim that a particular tax is paid by a particular group (sales taxes by consumers, corporate income taxes by corporations, income taxes by employees) who really pays the tax (from an economic incidence point of view) depends on relative elasticities. Lynne Kiesling from Knowledge Problem explains:

"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?)."

For economics students, the site Classic Economic Models has a terrific interactive model showing "who pays a sales tax" illustrating the importance of elasticity to economic incidence of taxation.

Where Legal Incidence and Economic Incidence Differ Dramatically

I hope the above quotations have convinced you that there can be a serious deviation between legal incidence, the kind shown from the Congressional Budget Office (CBO) statistics, and economic incidence. Because of that the CBO statistics do not show us how much each group 'really' pays for taxes, because it assumes that income tax is fully paid by workers, gasoline taxes are fully paid for by drivers, etc. etc.

One particularly troubling assumption made by the CBO is that corporate income taxes are paid for entirely by shareholders. How research indicates that this differs greatly from the research on economic incidence. Worthwhile Canadian Initiative quotes research by Michael Devereux that indicates corporate income taxes are largely passed along to workers:

..."[J]ust over half of an increase in tax liability would be passed on to the workforce in the short run. In the longer run, the fall in employee compensation would exceed the original increase in the tax liability. The effects found in Model 2 are even larger. There is also some evidence that for multinational companies, higher effective tax rates in other parts of the multinational group tend to have a positive effect on domestic wages."

If Devereux is correct and labor pays for more than the entire amount of corporate income taxation, then this fact alone would make economic incidence differ greatly from legal incidence.

I believe Alex Tabarrok was jumping to conclusions when he posted this data under the title The Rich Pay for the Federal Government. He may be correct, but since economic incidence can differ greatly from legal incidence (particularly for the corporate income tax), we simply cannot come to any conclusion on how much different groups really pay.