Individuals Pay Corporate Taxes – Just Not Always The Consumer

Right now, our corporate tax structure makes no sense.  It not only plays favorites, it drives many of the unfavored abroad.  We have the highest corporate tax rate in the world, and the code is so riddled with exceptions, subsidies, and loopholes, disguised as “incentives,” that, as Megan McArdle put it, large companies basically have branch offices of the IRS on site to negotiate their tax bills.

So it makes sense that we should lower the corporate tax rate in exchange for cleaning the thing up.

It makes sense for all sorts of reasons, but not for one reason you often hear mentioned: that corporations just pass the increase along to consumers.  They don’t.  At least not always, because they can’t.

Who pays the tax is known as, “tax incidence,” and it depends on who has the fewest options.  Economics recognizes something called, “elasticity.” Supply Elasticity is how much the supply changes depending on the price, and if you’ve been following along, you’ll know that Demand Elasticity is how much demand changes in response to price changes.  Vacation rentals have a pretty high demand elasticity.  Gasoline, on the other hand, has a fairly low demand elasticity: the price goes up, but you still have to get to work.

On the supply side, airline seats have a fairly low supply elasticity; once an airline has planes in inventory, they’re not likely to mothball them, at least not in the short run.  Tobacco, on the other hand, has a pretty high supply elasticity: when the price falls, supply falls quickly to match.

(A word for the pedantic: elasticity is not constant.  At very high or low price levels, we as consumers or producers may behave differently.  You can only drive so much, even at $1 a gallon, lowering demand elasticity.  Of course, at that price, there won’t be any refineries operating, either.  Also, there’s the economist’s eternal escape hatch – the long-run and the short-run.  It may be expensive for me to increase or limit supply, but give me enough time, and I’ll find a way.)

So what does this have to do with the tax on eggs in China?

If I’m the one with fewer choices, I’ll probably have to eat most of the tax.  Suppose, for example, I make the Indispensible Widget.  It’s easy for me to ramp up and ramp down production, but it’s a commodity you have to have, every day, all the time.  This gives me, as a producer, pricing power, and it means that when our taxes get raised, we can pretty much – up to a point – pass that expense along to you.   (Remember, even monopolies don’t have infinite pricing power, and even commodities producers have competition.)  So in that case, yes, it’s the consumer who gets shafted.

Now, suppose I sell something else, something where the industry can’t readily reduce supply, but you have a lot a choice in whether or not buy.  High-end vacation hotel rooms, for instance.  I may be able to reduce some operating costs, but those costs are what make them luxury.  And vacations are very price-sensitive.  There may be some times when I can just tack on the tax, but if I’m trying to compete with your staycation, I probably won’t.  My shareholders and employees will eat it.

Note that there’s a similar relationship at work with how shareholders and employees split their end of the deal, too.  Labor, too, has supply and demand price elasticity.  If your labor is a commodity, you may not get that raise this year, or may even get a pay cut or fired.  If you have specialized skills, ownership may not be able to pass the tax along to you, either.

The point here is that while individuals always pay corporate taxes, those individuals may be consumers, employees, or owners, depending on the business.  It’s not as simple as businesses just passing the cost on to their customers.

Why is this an argument for tax reform?  Hayek’s Pretense of Knowledge.  The government can’t really know, except in the coarsest way, what the tax incidence for the corporate income tax will be on a given industry.  Subsidies may end up going to industries that don’t need them, or that can’t find a good place to invest them.  They may reward employees, or not; they may help subsidize demand, or not.  And what was true yesterday may well not be true tomorrow.

Ideally, we would simply ditch the corporate income tax altogether.  Salaries and employment would rise, as would consumption, dividends, and investment, so the government would see a lot of that revenue come back immediately, and much more from growth.

But barring that, a flat rate, which instead of aiming for universal “fairness” accepts the fact that industries and businesses differ from one another, is the wisest course.

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