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C. Shifting and Incidence: A Tax on an Industry
No discussion of taxation, however brief, can overlook the famous problem of “the shifting and incidence” of taxation. In brief, who pays a tax? The person on whom it is levied, or someone else to whom the former is able to “shift” the tax? There are still economists, incredibly, who hew to the old nineteenth-century “equal diffusion” theory of taxation, which simply closes the problem by proclaiming that “all taxes are shifted to everyone,” so that there is no need to analyze each one in particular.42 This obscurantist tendency is fostered by treating “shifting” in too broad a way. Thus, if an income tax is levied on Jones at 80 percent, this will hurt not only Jones, but also—by decreasing Jones’ incentives as well as capacities—other consumers by reducing Jones’ work and savings. It is therefore true that the effects of taxation diffuse outward from the center of the target. But this is far from saying that Jones can simply shift the tax burden onto the shoulders of others. The concept of “shifting” will here be limited to the case where the payment of a tax can be directly transferred from the original payer to someone else, and will not be used when others suffer in addition to the original taxpayer. The latter may be called the “indirect effects” of the tax.
The first rule of shifting is that an income tax cannot be shifted. This formerly accepted truth in economics is now countered with the popular assumption that, for example, a tax on wages will spur unions to demand higher wages to compensate for the tax, and that therefore the tax on wages is shifted “forward” onto the employer, who, in turn, shifts it again forward onto the body of consumers. And yet almost every step in this commonly proclaimed sequence is an egregious fallacy. It is absurd, in the first place, to think that workers or unions wait quietly for a tax to galvanize them into making demands. Workers always want higher wages; unions always demand more. The question is: Will they get more? There is no reason to think that they can. A worker can get only the value of the discounted marginal productivity of his labor. No clamor will raise that productivity, and therefore none can raise the wage he earns from his employer. Union demands for higher wages will be treated as usual, i.e., they can be satisfied only at the cost of the unemployment of some of the work force in that industry. But this is true whether or not there has been a tax on wages; the tax will have nothing to do with the final wage set on the market.
The idea that the increased cost will be passed on to the consumer by the employer is an illustration of perhaps the single most widespread fallacy on taxation: that businessmen can simply shift their higher costs forward onto the consumers in the form of higher prices. All the economic theory expounded in this book shows the error of this doctrine. For the price of a given product is set by the demand schedules of the consumers. There is nothing in higher costs or higher taxes which, per se, increases these schedules; hence, any change in selling prices, whether higher or lower, will decrease the revenues of the business involved. For each business, on the market, tends to be, at all times, at its “maximum profit point” in relation to the consumers. Prices are already at their point of maximum return for the business; therefore, higher taxes or other costs imposed on the firm will reduce their net incomes rather than be smoothly and easily passed on to consumers. We thus arrive at this significant conclusion: no tax (not just an income tax) can ever be shifted forward.
Suppose that a particularly heavy tax—of whatever type—has been laid on a specific industry: say the liquor industry. What will be the effects? As we have noted, the tax will not simply be “passed on” to the consumers.43 Instead, the price of liquor will remain the same; the net income of the firms will decline. This will mean that returns will be lower to capital and enterprise in liquor than in other industries of the economy; marginal liquor firms will suffer losses and go out of business; and, in general, productive resources of all types will flow out of liquor and into other industries. The long-run effect, therefore, is to decrease the supply of liquor produced, and therefore, by the law of supply and demand, to raise the price of liquor on the market. However, as we have said above, this process—this diffusion of suffering over the economy—is hardly “shifting.” For the tax is not simply “passed on”; it only permeates to the consumers through hurting the industry taxed. The final result will be a distortion of the factors of production; fewer goods are now being produced than the consumers would prefer in the liquor industry; and too many goods, relatively to liquor, are being produced in the other industry.
Taxes, in short, can more readily be “shifted backward” than forward. Strictly, the result is not shifting because it is not a painless process. But it is clear that the backward process (backward to the factors of production) happens more quickly and directly than the effects on consumers. For losses or lowered profits to liquor firms will immediately lower their demand for land, labor, and capital factors of production; this falling of demand schedules will lower wages and rents earned in the liquor industry; and these lower earnings will induce a shift of labor, land and capital out of liquor and into other industries. The rapid “backward-shifting” is in harmony with the “Austrian” theory of consumption and production developed in this volume; for prices of factors are determined by the selling prices of the goods which they produce, and not vice versa (which would have to be the conclusion of the naive “shifting-forward” doctrine).
It should be noted that, in some cases, the industry itself can welcome a tax upon it, for the sake of conferring an indirect, but effective, monopolistic privilege on the supramarginal firms. Thus, a flat “license” tax will confer a particular privilege on the more heavily capitalized firms, which can more easily afford to pay the fee.
- 42. For a critique of this doctrine, see E.R.A. Seligman, The Shifting and Incidence of Taxation (New York: Macmillan & Co., 1899), pp. 122–36.
- 43. Businessmen are particularly prone to this “passing on” argument—obviously in an attempt to convince consumers that they are really paying any tax on that industry. Yet the argument is clearly belied by the very zeal of each industry to have its taxes lowered and to fight against a tax increase. If taxes could really be shifted so easily and businessmen were simply unpaid collection agents for the government, they would never protest a tax on their industry. (Perhaps this is the reason why almost no businessmen have protested being collection agents for withholding taxes on their workers!)