Matt Nolan explores how tax distorts behaviour and who ends up bearing the actual cost of a tax

By Matthew Nolan*

In my previous article, we touched on the idea of what tax was.

We noted that the mix of spending and tax was a way of redistributing resources within society.

Today, in part two of a six part series, we are going to focus in on tax. We are going to take spending as given – where spending exists to achieve a series of goals that government aims to achieve on behalf of society as a whole – and focus on how we use taxation to pay for that spending.

This will allow us to think about the related costs of taxation.  After this, we will be ready to spend the next four articles looking at different types of taxes.

(Note:  I had previously said there would be five articles on tax rather than six. However, I’ve now decided to write about four types of taxes, rather than three, leading to an additional article.)

What are distortions?

While it is obvious to think of the cost of tax as being the direct funds used to support government spending, in truth the cost of raising $1 of taxation will be more than the $1 for two reasons.

· Resources are required to raise the tax (ie the IRD, compliance costs).

· Taxation can change prices, and thus decisions about what to consume and produce.

In this article, we will concentrate on the second point (ie the way people’s choices are “distorted” by taxation).  These distortions depend significantly on how people who demand goods and services, and people who supply goods and services, respond to the tax system.

Let us take your income tax as an example.  Your cost to your employer is your gross salary. However you only receive a salary that is net of tax.

Taxation of this type creates a “wedge” between the price paid by the consumer (your employer in this case) and the price received by the person making/selling the product (you in this case).

The wedge means that taxation causes what economists call a “dead-weight loss”. Fundamentally, a dead-weight loss occurs when, in the absence of the tax, buyers and sellers would have been willing to trade – but once the tax is imposed they are no longer willing to.

The size of the distortion/dead-weight loss depends on how responsive people are to tax changes.

When we talk about how people respond to the imposition of a tax, we are talking about how people change the quantity they offer/demand based on a change in the price they receive/have to pay.  In economics, this concept is known as price elasticity.

The more elastic supply or demand is (so the more heavily people respond to a change in the price of a good they are trading), the greater the change in the production/consumption of that good and service will be in response to a change in price.

Therefore, the more elastic a demand or supply for a good is, the bigger the drop in transactions that will occur when a tax is put in place. 

The value placed on the lost transactions in this case represent the dead-weight loss.  The larger this dead-weight loss is, the less efficient a tax is stated to be.

The issue of efficiency becomes more complicated when we start to think of the fact that we are transferring resources over the broad economy (not a single market).

In this case even if demand for a good was perfectly inelastic (so that the quantity did not change with the tax), a tax hike would still drive a drop in consumers’ net income – which would lead to a change in demand for other goods and services.

If we then compensated people for this change, the relative price of our good is still higher – and as a result, over the economy as whole we still experience a form of dead-weight loss/inefficiency from tax.

Who bears the burden?

As we said last week, and discussed above, it is difficult to work out exactly what resources are shifted, and who ends up bearing the burden of a tax.  However, we can use some broad principles to help us understand what influences where this burden of tax falls.

Let us go back to the income tax example. In this case, the gross wage you see in your payslip is set given the knowledge that some tax will have to be paid – it is not the wage you would be given if you, and everyone you competed with for the job, didn’t have to pay tax!

The tax bill is in fact split between you and your employer, and we need to figure out a way to work out how this split takes place.

In economics we use the idea of “tax incidence” to figure out who pays the tax on a market transaction.

The concept of tax incidence comes back to the aforementioned idea of elasticity.  If, for example, the seller of a product will respond relatively less than the buyer to a change in prices (so that they are relatively price inelastic), the imposition of a tax will fall proportionally more on the seller!

For example, think about the ways you may respond in your workplace to a decline in you take home pay.  Your reaction to a drop in your take home pay depends on your outside options (eg how easy is it for you to find other work). 

If you are currently being paid far more than you would get from the benefit and other income while unemployed, but you have no other job options if you left your current job, then it will be unlikely you will try to change your job or rock the boat at work.  In economist lingo this means that your labour supply will be relatively inelastic – and as a result much of the burden of tax will fall on you!  However, if it was easy for you to find another job or adjust your hours of work (so your labour supply is elastic), the employer is likely to take on a lot of the burden of the tax themselves.

When we move out of a single market this issue gets more complicated again.

After all, if a tax reduces household incomes to spend on a range of products, some products will experience more of a drop in demand than others. 

Furthermore, taxes that may have small impacts on the allocation of goods now may have large effects down the line – due to the cumulative impact of changes in the level of capital and distortions in investment relative to their underlying best use.  As a result, the full burden of a tax is never clear – and thinking in terms of the tax incidence for a single market only helps to illuminate part of the underlying issue.

Tax principles, and a way forward

On the face of it, this suggests two broad principles when looking at tax that may conflict.  When a tax is imposed, we need to think carefully about who the burden falls on.  Furthermore, we should take into account this idea of “dead-weight loss” and as a result we should attempt to keep the overall loss of efficiency from taxation as small as possible for a given target level of government revenue/spending.

In the next article, we will take these principles and use them to think about a couple of tax systems poll taxes, and taxes on factors related to ability.

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Matt Nolan is a senior economist at Infometrics. You can contact him here »