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Who Bears the Burden of the Tax?

April 7, 2005

This question came into the Institute from Allen Sukholitsky, a study at Columbia:

I had a few exchanges with my professor about the producer/consumer burden of the excise tax and she gave me numbers that appeared to prove that an excise tax can be partially given to the consumer. She gave me 3 combinations of price/quantity to prove the point.
Combination A, this combination reflects normal market equilibrium without a tax: Price of a good is $10, quantity sold is 5. With no tax, the profit is 50 - 10 (for the cost of the 5th unit) = 40 minus the cost of 4 units. Combination B, this combination represented my suggestion that a producer should/must absorb the tax entirely: Price of a good is $10, tax is $2 thus profit is 50 - 10 (cost of 5th unit) - 10 (tax on 5 units) - cost of 4 units = 30 - cost of 4 units. Combination C, this combination represents my professors suggestion that the firm cut its production by one unit: Price of a good is $11, 4 units sold, tax is again $2 so profit is 44 - 8 (tax on 4 units) - cost of 4 units = 36 - cost of 4 units.
By increasing the price/lowering the quantity in combination C, the firm retained a higher profit than in combination B meaning that in increasing the price/lowering quantity, some of the firm's loss was shared by the consumer. Is this correct? Did I misunderstand what Murray Rothbard wrote when he said that an excise tax falls entirely on the producer?

My answer follows:

If the tax is an excise tax imposed on a single good, say a 20 percent tax on citrus products, than firms producing fresh oranges, grapefruits, lemons and citrus juices, ice pops, fruit salads etc. would initially face higher costs of production and diminished profits. As a result the marginal firms in the industry may suffer losses and go out of business while the more efficient firms would cut back on their outputs eventually causing the supply curves of citrus products to shift to the left along given demand curves. 

So the 20 percent tax itself could not simply be tacked onto the price by firms and passed on directly to consumers while they maintained their profits unchanged. It is in fact the destructive effect of the tax on firm's profits which works its way through supply and demand that eventually causes prices to rise to consumers. Second, because consumers can and will substitute other types of fruits and juices as citrus prices rise, firms will not be able to increase prices by the full 20 percent; depending on the availability of substitutes and the elasticities of the demand curves, the percentage increase in price could be a great deal or only a little less than 20 percent.

Up to this point the Austrian analysis pretty much follows the standard neoclassical analysis of an excise tax. Ultimately, in the long run--and this is the distinctive Austrian point--the brunt of the tax will be shifted backwards to the owners of the original factors specific to citrus fruit production, in this case, citrus growers who own the orange and lemon groves whose capital values will fall greatly as a result of the fall in the demand for raw citrus produce. The workers in these areas, unless they are highly specialized in citrus fruit production, will not suffer a great loss of income because their services are nonspecific and they will be able to leave to find jobs at nearly comparable wages in other agricultural industries if the citrus growers try to lower their wages.

Consumers will suffer however to the extent that the least efficient growers stop producing and allow their land to lie fallow because they can't even cover their wage bills. If this occurs there will be a greater scarcity of citrus products and permanently higher prices to consumers. The higher the tax, the greater this latter effect will be.

A real world illustration is what happened to the yacht industry in New Jersey in the early 1990's when congress passed a 50 percent luxury tax on autos, airplanes and boats over $100,000. The demand for these luxury items were so elastic that yacht orders fell from around 400 the year before to 10 the year after the tax. Almost all yacht builders closed down and many of their specialized workers had to take much lower paying jobs as crabbers, fishermen, boat guides etc. Consumers faced much higher prices for yachts even in the long run until the tax was repealed.

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