Books / Digital Text
A. The General Sales Tax and the Laws of Incidence
One of the oldest problems connected with taxation is: Who pays the tax? It would seem that the answer is clear-cut, since the government knows on whom it levies a tax. The problem, however, is not who pays the tax immediately, but who pays it in the long run, i.e., whether or not the tax can be “shifted” from the immediate taxpayer to somebody else. Shifting occurs if the immediate taxpayer is able to raise his selling price to cover the tax, thus “shifting” the tax to the buyer, or if he is able to lower the buying price of something he buys, thus “shifting” the tax to some other seller.
In addition to this problem of the incidence of taxation, there is the problem of analyzing other economic effects of various types and amounts of taxes.
The first law of incidence can be laid down immediately, and it is a rather radical one: No tax can be shifted forward. In other words, no tax can be shifted from seller to buyer and on to the ultimate consumer. Below, we shall see how this applies specifically to excise and sales taxes, which are commonly thought to be shifted forward. It is generally considered that any tax on production or sales increases the cost of production and therefore is passed on as an increase in price to the consumer. Prices, however, are never determined by costs of production, but rather the reverse is true. The price of a good is determined by its total stock in existence and the demand schedule for it on the market. But the demand schedule is not affected at all by the tax. The selling price is set by any firm at the maximum net revenue point, and any higher price, given the demand schedule, will simply decrease net revenue. A tax, therefore, cannot be passed on to the consumer.
It is true that a tax can be shifted forward, in a sense, if the tax causes the supply of the good to decrease, and therefore the price to rise on the market. This can hardly be called shifting per se, however, for shifting implies that the tax is passed on with little or no trouble to the producer. If some producers must go out of business in order for the tax to be “shifted,” it is hardly shifting in the proper sense but should be placed in the category of other effects of taxation.
A general sales tax is the classic example of a tax on producers that is believed to be shifted forward. The government, let us say, imposes a 20-percent tax on all sales at retail. We shall assume that the tax can be equally well enforced in all branches of sales.10 To most people, it seems obvious that the business will simply add 20 percent to their selling prices and merely serve as unpaid collection agencies for the government. The problem is hardly that simple, however. In fact, as we have seen, there is no reason whatever to believe that prices can be raised at all. Prices are already at the point of maximum net revenue, the stock has not been decreased, and demand schedules have not changed. Therefore, prices cannot be increased. Furthermore, if we look at the general array of prices, these are determined by the supply of and the demand for money. For the array of prices to rise, there must be an increase in the supply of money, a decrease in the schedule of the demand for money, or both. Yet neither of these alternatives has occurred. The demand for money to hold has not decreased, the supply of goods available for money has not declined, and the supply of money has remained constant. There is no possible way that a general price increase can be obtained.11
It should be quite evident that if businesses were able to pass tax increases along to the consumer in the form of higher prices, they would have raised these prices already without waiting for the spur of a tax increase. Businesses do not deliberately peg along at the lowest selling prices they can find. If the state of demand had permitted higher prices, firms would have taken advantage of this fact long before. It might be objected that a sales tax increase is general and therefore that all the firms together can shift the tax. Each firm, however, follows the state of the demand curve for its own product, and none of these demand curves has changed. A tax increase does nothing to make higher prices more profitable.
The myth that a sales tax can be shifted forward is comparable to the myth that a general union-imposed wage increase can be shifted forward to higher prices, thereby “causing inflation.” There is no way that the general array of prices can rise, and the only result of such a wage increase will be mass unemployment.12
Many people are misled by the fact that the price the consumer pays must necessarily include the tax. When someone goes to a movie and sees prominently posted the information that the $1.00 admission covers a “price” of 85 cents and a tax of 15 cents, he tends to conclude that the tax has simply been added on to the “price.” But $1.00 is the price, not 85 cents, the latter sum being the income accruing to the firm after taxes. This income might well have been reduced to allow for payment of taxes.
In fact, this is precisely the effect of a general sales tax. Its immediate impact lowers the gross revenue of firms by the amount of the tax. In the long run, of course, firms cannot pay the tax, for their loss in gross revenue is imputed back to interest income by capitalists and to wages and rents earned by original factors—labor and ground land. A decrease in the gross revenue of retail firms is reflected back to a decreased demand for the products of all the higher-order firms. All the firms, however, earn, in the long run, a pure uniform interest return.
Here a difference arises between a general sales tax and, say, a corporate income tax. There has been no change in time-preference schedules or other components of the interest rate. While an income tax compels a lower percent interest return, a sales tax can and will be shifted completely from investment and back to the original factors. The result of a general sales tax is a general reduction in the net revenue accruing to original factors: to all wages and ground rents. The sales tax has been shifted backwards to original factor returns. No longer does every original factor of production earn its discounted marginal value product. Now, original factors earn less than their DMVPs, the reduction consisting of the sales tax paid to the government.
It is necessary now to integrate this analysis of the incidence of a general sales tax with our previous general analysis of the benefits and burdens of taxation. This is accomplished by remembering that the proceeds of taxation are, in turn, spent by the government.13 Whether the government spends the money for resources for its own activities or simply transfers the money to people it subsidizes, the result is to shift consumption and investment demand from private hands to the government or to government-supported individuals, by the amount of the tax revenue. In this case, the tax has been ultimately levied on the incomes of original factors, and the money transferred from their hands to the government. The income of the government and/or those it subsidizes has been increased at the expense of those taxed, and therefore consumption and investment demands on the market have been shifted from the latter to the former by the amount of the tax. As a consequence, the value of the money unit will remain unchanged (barring a difference in demands for money between the taxpayers and the tax consumers), but the array of prices will shift in accordance with the shift in demands. Thus, if the market has been spending heavily on clothing, and the government uses the revenue mostly for the purchase of arms, there will be a fall in the price of clothes, a rise in the price of arms, and a tendency for nonspecific factors to shift out of clothing and into the production of armaments.
As a result, there will not be, as might be assumed, a proportional 20-percent fall in the incomes of all original factors as a result of a 20-percent general sales tax. Specific factors in industries that have lost business as a result of the shift from private to governmental demand will lose proportionately more in income. Specific factors in industries gaining in demand will lose proportionately less, and some may gain so much as to gain absolutely as a result of the change. Nonspecific factors will not be affected as much proportionately, but they too will lose and gain according to the difference that the concrete shift in demand makes in their marginal value productivity.
The knowledge that taxes can never be shifted forward is a consequence of adhering to the “Austrian” analysis of value, i.e., that prices are determined by ultimate demands for stock, and not in any sense by the “cost of production.” Unhappily, all previous discussions of the incidence of taxation have been marred by hangovers of classical “cost-of-production” theory and the failure to adopt a consistent “Austrian” approach. The Austrian economists themselves never really applied their doctrines to the theory of tax incidence, so that this discussion breaks new ground.
The shifting-forward doctrine has actually been carried to its logical, and absurd, conclusion that producers shift taxes to consumers, and consumers, in turn, can shift them to their employers, and so on ad infinitum, with no one really paying any tax at all.14
It should be carefully noted that the general sales tax is a conspicuous example of failure to tax consumption. It is commonly supposed that a sales tax penalizes consumption rather than income or capital. But we find that the sales tax reduces, not just consumption, but the incomes of original factors. The general sales tax is an income tax, albeit a rather haphazard one, since there is no way that its impact on income classes can be made uniform. Many “right-wing” economists have advocated general sales taxation, as opposed to income taxation, on the ground that the former taxes consumption but not savings-investment; many “left-wing” economists have opposed sales taxation for the same reason. Both are mistaken; the sales tax is an income tax, though of more haphazard and uncertain incidence. The major effect of the general sales tax will be that of the income tax: to reduce the consumption and the savings-investment of the taxpayers.15 In fact, since, as we shall see, the income tax by its nature falls more heavily on savings-investment than on consumption, we reach the paradoxical and important conclusion that a tax on consumption will also fall more heavily on savings-investment, in its ultimate incidence.
- 10. Usually, of course, it cannot, and the result will be equivalent to a specific excise tax on some branches of sales, but not on others.
- 11. Whereas a partial excise tax will eventually cause a drop in supply and therefore a rise in the price of the product, there is no way by which resources can escape a general tax except into idleness. Since, as we shall see, a sales tax is a tax on incomes, the rise in the opportunity cost of leisure may push some workers into idleness, and thereby lower the quantity of goods produced. To this tenuous extent, prices will rise. See the pioneering article by Harry Gunnison Brown, “The Incidence of a General Sales Tax,” reprinted in R.A. Musgrave and C.S. Shoup, eds., Readings in the Economics of Taxation (Homewood, Ill.: Richard D. Irwin, 1959), pp. 330–39. This was the first modern attack on the fallacy that sales taxes are shifted forward, but Brown unfortunately weakened the implications of this thesis toward the end of his article.
- 12. Of course, if the money supply is increased and credit expanded, prices can be raised so that money wages are no longer above their discounted marginal value products.
- 13. If the government does not spend all of its revenue, then deflation is added to the impact of taxation. See below.
- 14. For example, see E.R.A. Seligman, The Shifting and Incidence of Taxation (2nd ed.; New York: Macmillan & Co., 1899), pp. 122–33.
- 15. Mr. Frank Chodorov, in his The Income Tax—Root of All Evil (New York: Devin-Adair, 1954), fails to indicate what other type of tax would be “better” from a free-market point of view than the income tax. It will be clear from our discussion that there are few taxes indeed that will not be as bad as the income tax from the viewpoint of an advocate of the free market. Certainly, sales or excise taxation will not fill the bill.
Chodorov, furthermore, is surely wrong when he terms income and inheritance taxes unique denials of the right of individual property. Any tax whatever infringes on property rights, and there is nothing in an “indirect tax” which makes that infringement any less clear. It is true that an income tax forces the subject to keep records and disclose his personal dealings, thus imposing a further loss in his utility. The sales tax, however, also forces record-keeping; the difference again is one of degree rather than of kind, for here the extent of directness covers only retail storekeepers instead of the bulk of the population.