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State and local governments also levy individual and corporate income taxes. In many cases, state and local income taxes are similar to federal income taxes. In other cases, they are quite different. For example, some states tax income from wages less heavily than income earned in the form of interest and dividends. Some states do not tax income at all.

State and local governments also receive substantial funds from the federal government. To some extent, the federal government's policy of sharing its revenue with state governments redistributes funds from high-income states (which pay more taxes) to low-income states (which receive more benefits). Often, these funds are tied to specific programs that the federal government wants to subsidize.

Finally, state and local governments receive much of their receipts from various sources included in the “other” category in Table 5. These include fees for fishing and hunting licenses, tolls from roads and bridges, and fares for public buses and subways.

Spending Table 6 shows the total spending of state and local governments in 2011 and its breakdown among the major categories.

By far the biggest single expenditure for state and local governments is education. Local governments pay for the public schools, which educate most students from kindergarten through high school. State governments contribute to the support of public universities. In 2011, education accounted for about a third of the spending of state and local governments.

The second largest category of spending is for health programs, such as Medicaid, followed by spending on public order and safety, which includes the police, firefighters, courts, and prisons. Next come income security programs, the building and maintenance of roads and highways, and interest on state and local government debt. The “other” category in Table 6 includes the many additional services provided by state and local governments, such as libraries, garbage and snow removal, and the maintenance of public parks and playgrounds.

Quick Quiz What are the two most important sources of tax revenue for the federal government? • What are the two most important sources of tax revenue for state and local governments?

TABLE 6 Spending of State and Local Governments: 2011

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Source: Bureau of Economic Analysis. Columns may not sum to total due to rounding.

12-2 Taxes and Efficiency

Now that we have seen how various levels of the U.S. government raise and spend money, let's consider how one might evaluate its tax policy and design a tax system. The primary aim of a tax system is to raise revenue for the government, but there are many ways to raise any given amount of money. When choosing among the many alternative tax systems, policymakers have two objectives: efficiency and equity.

One tax system is more efficient than another if it raises the same amount of revenue at a smaller cost to taxpayers. What are the costs of taxes to taxpayers? The most obvious cost is the tax payment itself. This transfer of money from the taxpayer to the government is an inevitable feature of any tax system. Yet taxes also impose two other costs, which well-designed tax policy tries to avoid or, at least, minimize:

The deadweight losses that result when taxes distort the decisions that people make; The administrative burdens that taxpayers bear as they comply with the tax laws.

An efficient tax system is one that imposes small deadweight losses and small administrative burdens.

“I was gonna fix the place up, but if I did, the city would just raise my taxes!”

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12-2a Deadweight Losses

One of the Ten Principles of Economics is that people respond to incentives, and this includes incentives provided by the tax system. If the government taxes ice cream, people eat less ice cream and more frozen yogurt. If the government taxes housing, people live in smaller houses and spend more of their income on other things. If the government taxes labor earnings, people work less and enjoy more leisure.

Because taxes distort incentives, they entail deadweight losses. As we first discussed in Chapter 8, the deadweight loss of a tax is the reduction in economic well-being of taxpayers in excess of the amount of revenue raised by the government. The deadweight loss is the inefficiency that a tax creates as people allocate resources according to the tax incentive rather than the true costs and benefits of the goods and services that they buy and sell.

To recall how taxes cause deadweight losses, consider an example. Suppose that Joe places an $8 value on a pizza and Jane places a $6 value on it. If there is no tax on pizza, the price of pizza will reflect the cost of making it. Let's suppose that the price of pizza is $5, so both Joe and Jane choose to

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buy one. Both consumers get some surplus of value over the amount paid. Joe gets consumer surplus of $3, and Jane gets consumer surplus of $1. Total surplus is $4.

Now suppose that the government levies a $2 tax on pizza and the price of pizza rises to $7. (This occurs if supply is perfectly elastic.) Joe still buys a pizza, but now he has consumer surplus of only $1. Jane now decides not to buy a pizza because its price is higher than its value to her. The government collects tax revenue of $2 on Joe's pizza. Total consumer surplus has fallen by $3 (from $4 to $1). Because total surplus has fallen by more than the tax revenue, the tax has a deadweight loss. In this case, the deadweight loss is $1.

Notice that the deadweight loss comes not from Joe, the person who pays the tax, but from Jane, the person who doesn't. The reduction of $2 in Joe's surplus exactly offsets the amount of revenue the government collects. The deadweight loss arises because the tax causes Jane to alter her behavior. When the tax raises the price of pizza, Jane is worse off, and yet there is no offsetting revenue to the government. This reduction in Jane's welfare is the deadweight loss of the tax.

case study Should Income or Consumption Be Taxed? When taxes induce people to change their behavior—such as inducing Jane to buy less pizza—the taxes cause deadweight losses and make the allocation of resources less efficient. As we have already seen, much government revenue comes from the individual income tax. In a case study in Chapter 8, we discussed how this tax discourages people from working as hard as they otherwise might. Another inefficiency caused by this tax is that it discourages people from saving.

Consider a person 25 years old who is considering saving $1,000. If he puts this money in a savings account that earns 8 percent and leaves it there, he will have $21,720 when he retires at age 65. Yet if the government taxes one-fourth of his interest income each year, the effective interest rate is only 6 percent. After 40 years of earning 6 percent, the $1,000 grows to only $10,290, less than half of what it would have been without taxation. Thus, because interest income is taxed, saving is much less attractive.

Some economists advocate eliminating the current tax system's disincentive toward saving by changing the basis of taxation. Rather than taxing the amount of

income that people earn, the government could tax the amount that people spend. Under this proposal, all income that is saved would not be taxed until the saving is later spent. This alternative system, called a consumption tax, would not distort people's saving decisions.

Various provisions of current law already make the tax system a bit like a consumption tax. Taxpayers can put a limited amount of their income into special savings accounts, such as Individual Retirement Accounts and 401(k) plans, and this income and the accumulated interest it earns escape taxation until the money is withdrawn at retirement. For people who do most of their saving through these retirement accounts, their tax bill is, in effect, based on their consumption rather than their income.

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European countries tend to rely more on consumption taxes than does the United States. Most of them raise a significant amount of government revenue through a value-added tax, or a VAT. A VAT is like the retail sales tax that many U.S. states use. But rather than collecting all of the tax at the retail level when the consumer buys the final good, the government collects the tax in stages as the good is being produced (that is, as value is added by firms along the chain of production).

Various U.S. policymakers have proposed that the tax code move further in the direction of taxing consumption rather than income. In 2005, economist Alan Greenspan, then Chairman of the Federal Reserve, offered this advice to a presidential commission on tax reform: “As you know, many economists believe that a consumption tax would be best from the perspective of promoting economic growth—particularly if one were designing a tax system from scratch—because a consumption tax is likely to encourage saving and capital formation. However, getting from the current tax system to a consumption tax raises a challenging set of transition issues.”

12-2b Administrative Burden If you ask the typical person on April 15 for an opinion about the tax system, you might get an earful (perhaps peppered with expletives) about the headache of filling out tax forms. The administrative burden of any tax system is part of the inefficiency it creates. This burden includes not only the time spent in early April filling out forms but also the time spent throughout the year keeping records for tax purposes and the resources the government has to use to enforce the tax laws.

Many taxpayers—especially those in higher tax brackets—hire tax lawyers and accountants to help them with their taxes. These experts in the complex tax laws fill out the tax forms for their clients and help them arrange their affairs in a way that reduces the amount of taxes owed. This behavior is legal tax avoidance, which is different from illegal tax evasion.

Critics of our tax system say that these advisers help their clients avoid taxes by abusing some of the detailed provisions of the tax code, often dubbed “loopholes.” In some cases, loopholes are congressional mistakes: They arise from ambiguities or omissions in the tax laws. More often, they arise because Congress has chosen to give special treatment to specific types of behavior. For example, the U.S. federal tax code gives preferential treatment to investors in municipal bonds because Congress wanted to make it easier for state and local governments to borrow money. To some extent, this provision benefits states and localities; and to some extent, it benefits high-income taxpayers. Most loopholes are well known

by those in Congress who make tax policy, but what looks like a loophole to one taxpayer may look like a justifiable tax deduction to another.

The resources devoted to complying with the tax laws are a type of deadweight loss. The government gets only the amount of taxes paid. By contrast, the taxpayer loses not only this amount but also the time and money spent documenting, computing, and avoiding taxes.

The administrative burden of the tax system could be reduced by simplifying the tax laws. Yet

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simplification is often politically difficult. Most people are ready to simplify the tax code by eliminating the loopholes that benefit others, but few are eager to give up the loopholes that they benefit from themselves. In the end, the complexity of the tax law results from the political process as various taxpayers with their own special interests lobby for their causes.

12-2c Marginal Tax Rates versus Average Tax Rates When discussing the efficiency and equity of income taxes, economists distinguish between two notions of the tax rate: the average and the marginal. The average tax rate is total taxes paid divided by total income. The marginal tax rate is the amount that taxes increase from an additional dollar of income.

average tax rate total taxes paid divided by total income marginal tax rate the amount that taxes increase from an additional dollar of income

For example, suppose that the government taxes 20 percent of the first $50,000 of income and 50 percent of all income above $50,000. Under this tax, a person who makes $60,000 pays a tax of $15,000: 20 percent of the first $50,000 (0.20 × $50,000 = $10,000) plus 50 percent of the next $10,000 (0.50 × $10,000 = $5,000). For this person, the average tax rate is $15,000/$60,000, or 25 percent. But the marginal tax rate is 50 percent. If the taxpayer earned an additional dollar of income, that dollar would be subject to the 50 percent tax rate, so the amount the taxpayer would owe to the government would rise by $0.50.

The marginal and average tax rates each contain a useful piece of information. If we are trying to gauge the sacrifice made by a taxpayer, the average tax rate is more appropriate because it measures the fraction of income paid in taxes. By contrast, if we are trying to gauge how much the tax system distorts incentives, the marginal tax rate is more meaningful. One of the Ten Principles of Economics in Chapter 1 is that rational people think at the margin. A corollary to this principle is that the marginal tax rate measures how much the tax system discourages people from working. If you are thinking of working an extra few hours, the marginal tax rate determines how much the government takes of your additional earnings. It is the marginal tax rate, therefore, that determines the deadweight loss of an income tax.

12-2d Lump-Sum Taxes Suppose the government imposes a tax of $4,000 on everyone, That is, everyone owes the same amount, regardless of earnings or any actions that a person might take. Such a tax is called a lump- sum tax.

A lump-sum tax shows clearly the difference between average and marginal tax rates. For a taxpayer with income of $20,000, the average tax rate of a $4,000 lump-sum tax is 20 percent; for a taxpayer with income of $40,000, the average tax rate is 10 percent. For both taxpayers, the marginal tax rate is zero because no tax is owed on an additional dollar of income.

lump-sum tax a tax that is the same amount for every person

A lump-sum tax is the most efficient tax possible. Because a person's decisions do not alter the amount owed, the tax does not distort incentives and, therefore, does not cause deadweight losses. Because everyone can easily compute the amount owed and because there is no benefit to hiring tax

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lawyers and accountants, the lump-sum tax imposes a minimal administrative burden on taxpayers.

If lump-sum taxes are so efficient, why do we rarely observe them in the real world? The reason is that efficiency is only one goal of the tax system. A lump-sum tax would take the same amount from the poor and the rich, an outcome most people would view as unfair. To understand the tax systems that we observe, we must therefore consider the other major goal of tax policy: equity.

Quick Quiz What is meant by the efficiency of a tax system? • What can make a tax system inefficient?

12-3 Taxes and Equity Ever since American colonists dumped imported tea into Boston harbor to protest high British taxes, tax policy has generated some of the most heated debates in American politics. The heat is rarely fueled by questions of efficiency. Instead, it arises from disagreements over how the tax burden should be distributed. Senator Russell Long once mimicked the public debate with this ditty:

Don't tax you. Don't tax me. Tax that fella behind the tree.

Of course, if we are to rely on the government to provide some of the goods and services we want, taxes must fall on someone. In this section, we consider the equity of a tax system. How should the burden of taxes be divided among the population? How do we evaluate whether a tax system is fair? Everyone agrees that the tax system should be equitable, but there is much disagreement about how to judge the equity of a tax system.

12-3a The Benefits Principle One principle of taxation, called the benefits principle, states that people should pay taxes based on the benefits they receive from government services. This principle tries to make public goods similar to private goods. It seems fair that a person who often goes to the movies pays more in total for movie tickets than a person who rarely goes. Similarly, a person who gets great benefit from a public good should pay more for it than a person who gets little benefit.

benefits principle the idea that people should pay taxes based on the benefits they receive from government services

The gasoline tax, for instance, is sometimes justified using the benefits principle. In some states, revenues from the gasoline tax are used to build and maintain roads. Because those who buy gasoline are the same people who use the roads, the gasoline tax might be viewed as a fair way to pay for this government service.

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The benefits principle can also be used to argue that wealthy citizens should pay higher taxes than poorer ones. Why? Simply because the wealthy benefit more from public services. Consider, for example, the benefits of police protection from theft. Citizens with much to protect benefit more from police than do those with less to protect. Therefore, according to the benefits principle, the wealthy should contribute more than the poor to the cost of maintaining the police force. The same argument can be used for many other public services, such as fire protection, national defense, and the court system.

It is even possible to use the benefits principle to argue for antipoverty programs funded by taxes on the wealthy. As we discussed in Chapter 11, people may prefer living in a society without poverty, suggesting that antipoverty programs are a public good. If the wealthy place a greater dollar value on this public good than members of the middle class do, perhaps just because the wealthy have more to spend, then according to the benefits principle, they should be taxed more heavily to pay for these programs.

12-3b The Ability-to-Pay Principle Another way to evaluate the equity of a tax system is called the ability-to-pay principle, which states that taxes should be levied on a person according to how well that person can shoulder the burden. This principle is sometimes justified by the claim that all citizens should make an “equal sacrifice” to support the government. The magnitude of a person's sacrifice, however, depends not only on the size of his tax payment but also on his income and other circumstances. A $1,000 tax paid by a poor person may require a larger sacrifice than a $10,000 tax paid by a rich one.

ability-to-pay principle the idea that taxes should be levied on a person according to how well that person can shoulder the burden

The ability-to-pay principle leads to two corollary notions of equity: vertical equity and horizontal equity. Vertical equity states that taxpayers with a greater ability to pay should contribute a larger amount. Horizontal equity states that taxpayers with similar abilities to pay should contribute the same amount. These notions of equity are widely accepted, but applying them to evaluate a tax system is rarely straightforward.

vertical equity the idea that taxpayers with a greater ability to pay taxes should pay larger amounts horizontal equity the idea that taxpayers with similar abilities to pay taxes should pay the same amount

Vertical Equity If taxes are based on ability to pay, then richer taxpayers should pay more than poorer taxpayers. But how much more should the rich pay? Much of the debate over tax policy concerns this question.

Consider the three tax systems in Table 7. In each case, taxpayers with higher incomes pay more.

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Yet the systems differ in how quickly taxes rise with income. The first system is called proportional because all taxpayers pay the same fraction of income. The second system is called regressive because high-income taxpayers pay a smaller fraction of their income, even though they pay a larger amount. The third system is called progressive because high-income taxpayers pay a larger fraction of their income.

proportional tax a tax for which high-income and low-income taxpayers pay the same fraction of income regressive tax a tax for which high-income taxpayers pay a smaller fraction of their income than do low-income taxpayers progressive tax a tax for which high-income taxpayers pay a larger fraction of their income than do low-income taxpayers

Which of these three tax systems is most fair? There is no obvious answer, and economic theory does not offer any help in trying to find one. Equity, like beauty, is in the eye of the beholder.

TABLE 7 Three Tax Systems

case study How the Tax Burden Is Distributed

Much debate over tax policy concerns whether the wealthy pay their fair share. There is no objective way to make this judgment. In evaluating the issue for yourself, however, it is useful to know how much families with different incomes pay under the current tax system.

Table 8 presents some data on how federal taxes are distributed among income classes. These figures are for 2009, the most recent year available as this book was going to press, and were tabulated by the Congressional Budget Office. They include all federal taxes—individual income taxes, payroll taxes, corporate income taxes, and excise taxes—but not state and local taxes. When calculating a household's tax burden, the CBO allocates corporate income taxes to the owners of

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capital and payroll taxes to workers. To construct the table, households are ranked according to their income and placed into five

groups of equal size, called quintiles. The table also presents data on the richest 1 percent of Americans. The second column of the table shows the average income of each group. Income includes both market income (income that households have earned from their work and savings) and transfer payments from government programs, such as Social Security and welfare. The poorest one-fifth of households had average income of $23,500, and the richest one-fifth had average income of $223,500. The richest 1 percent had average income of over $1.2 million.

The third column of the table shows total taxes as a percentage of income. As you can see, the U.S. federal tax system is progressive. The poorest fifth of households paid 1.0 percent of their incomes in taxes, and the richest fifth paid 23.2 percent. The top 1 percent paid 28.9 percent of their incomes.

The fourth and fifth columns compare the distribution of income and the distribution of taxes. The poorest quintile earned 5.1 percent of all income and paid 0.3 percent of all taxes. The richest quintile earned 50.8 percent of all income and paid 67.9 percent of all taxes. The richest 1 percent (which, remember, is size of each quintile) earned 13.4 percent of all income and paid 22.3 percent of all taxes.

These numbers on taxes paid are a good starting point for understanding how the burden of government is distributed, but they give an incomplete picture. Money flows not only from households to the government in the form of taxes but also from the government back to households in the form of transfer payments. In some ways, transfer payments are the opposite of taxes. Including transfers as negative taxes substantially changes the distribution of the tax burden. The richest

quintile of households still pays about one-quarter of its income to the government, even after transfers are subtracted, and the top 1 percent still pays almost 30 percent. By contrast, the average tax rate for the poorest quintile becomes a sizeable negative number. That is, typical households in the bottom of the income distribution receive substantially more in transfers than they pay in taxes. The lesson is clear: To understand fully the progressivity of government policies, one must take account of both what people pay and what they receive.

TABLE 8 The Burden of Federal Taxes

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Source: Congressional Budget Office Analysis. Figures are for 2009.

Finally, it is worth noting that the numbers in Table 8 are a bit out of date. In late 2012, the U.S. Congress passed and President Obama signed a tax bill that increased taxes significantly from those that prevailed previously, particularly for taxpayers at the top of the income distribution. For individuals earning taxable income more than $400,000 and couples earning more than $450,000, the marginal income tax rate was increased from 35 to 39.6 percent. As a result, the tax system in place for 2013 and beyond is more progressive than the one shown in the table.

Horizontal Equity If taxes are based on ability to pay, then similar taxpayers should pay similar amounts of taxes. But what determines if two taxpayers are similar? Families differ in many ways. To evaluate whether a tax code is horizontally equitable, one must determine which differences are relevant for a family's ability to pay and which differences are not.

Suppose the Smith and Jones families each have income of $100,000. The Smiths have no children, but Mr. Smith has an illness that results in medical expenses of $40,000. The Joneses are in good health, but they have four children. Two of the Jones children are in college, generating tuition bills of $60,000. Would it be fair for these two families to pay the same tax because they have the same income? Would it be fair to give the Smiths a tax break to help them offset their high medical expenses? Would it be fair to give the Joneses a tax break to help them with their tuition expenses?

There are no easy answers to these questions. In practice, the U.S. tax code is filled with special provisions that alter a family's tax obligations based on its specific circumstances.

12-3c Tax Incidence and Tax Equity Tax incidence—the study of who bears the burden of taxes—is central to evaluating tax equity. As we first saw in Chapter 6, the person who bears the burden of a tax is not always the person who gets the tax bill from the government. Because taxes alter supply and demand, they alter equilibrium prices. As a result, they affect people beyond those who, according to statute, actually pay the tax. When evaluating the vertical and horizontal equity of any tax, it is important to take these indirect effects into account.

Many discussions of tax equity ignore the indirect effects of taxes and are based on what economists mockingly call the flypaper theory of tax incidence. According to this theory, the burden of a tax, like a fly on flypaper, sticks wherever it first lands. This assumption, however, is rarely valid.

For example, a person not trained in economics might argue that a tax on expensive fur coats is

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S

vertically equitable because most buyers of furs are wealthy. Yet if these buyers can easily substitute other luxuries for furs, then a tax on furs might only reduce the sale of furs. In the end, the burden of the tax will fall more on those who make and sell furs than on those who buy them. Because most workers who make furs are not wealthy, the equity of a fur tax could be quite different from what the flypaper theory indicates.

IN THE NEWS Tax Expenditures

Tax reformers and deficit hawks often suggest reducing the deductions, credits, and exclusions that narrow the tax base. The Blur Between Spending and Taxes By N. Gregory Mankiw

hould the government cut spending or raise taxes to deal with its long-term fiscal imbalance? As President Obama's deficit commission rolls out its final report in the coming weeks, this

issue will most likely divide the political right and left. But, in many ways, the question is the wrong one. The distinction between spending and taxation is often murky and sometimes meaningless.

Imagine that there is some activity—say, snipe hunting—that members of Congress want to encourage. Senator Porkbelly proposes a government subsidy. “America needs more snipe hunters,” he says. “I propose that every time an American bags a snipe, the federal government should pay him or her $100.”

“No, no,” says Congressman Blowhard. “The Porkbelly plan would increase the size of an already bloated government. Let's instead reduce the burden of taxation. I propose that every time an American tracks down a snipe, the hunter should get a $100 credit to reduce his or her tax liabilities.”

To be sure, government accountants may treat the Porkbelly and Blowhard plans differently. They

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would likely deem the subsidy to be a spending increase and the credit to be a tax cut. Moreover, the rhetoric of the two politicians about spending and taxes may appeal to different political bases.

But it hardly takes an economic genius to see how little difference there is between the two plans. Both policies enrich the nation's snipe hunters. And because the government must balance its books, at least in the long run, the gains of the snipe hunters must come at the cost of higher taxes or lower government benefits for the rest of us.

Economists call the Blowhard plan a “tax expenditure.” The tax code is filled with them— although not yet one for snipe hunting. Every time a politician promises a “targeted tax cut,” he or she is probably offering up a form of government spending in disguise.

Erskine B. Bowles and Alan K. Simpson, the chairmen of President Obama's deficit reduction commission, have taken at hard look at these tax expenditures—and they don't like what they see. In their draft proposal, released earlier this month, they proposed doing away with tax expenditures, which together cost the Treasury over $1 trillion a year.

Such a drastic step would allow Mr. Bowles and Mr. Simpson to move the budget toward fiscal sustainability, while simultaneously reducing all income tax rates. Under their plan, the top tax rate would fall to 23 percent from the 35 percent in today's law (and the 39.6 percent currently advocated by Democratic leadership).

This approach has long been the basic recipe for tax reform. By broadening the tax base and lowering tax rates, we can increase government revenue and distort incentives less. That should command widespread applause across the ideological spectrum. Unfortunately, the reaction has been less enthusiastic.

Pundits on the left are suspicious of any plan that reduces marginal tax rates on the rich. But, as Mr. Bowles and Mr. Simpson point out, tax expenditures disproportionately

benefit those at the top of the economic ladder. According to their figures, tax expenditures increase the after-tax income of those in the bottom quintile by about 6 percent. Those in the top 1 percent of the income distribution enjoy about twice that gain. Progressives who are concerned about the gap between rich and poor should be eager to scale back tax expenditures.

Pundits on the right, meanwhile, are suspicious of anything that increases government revenue. But they should recognize that tax expenditures are best viewed as a hidden form of spending. If we eliminate tax expenditures and reduce marginal tax rates, as Mr. Bowles and Mr. Simpson propose, we are essentially doing what economic conservatives have long advocated: cutting spending and taxes.

Yet another political problem is that each tax expenditure has its own political constituency. If Congressman Blowhard ever got his way, the snipe hunters of the world would surely fight to keep their tax break.

One major tax expenditure that the Bowles-Simpson plan would curtail or eliminate is the mortgage interest deduction. Without doubt, many homeowners and the real estate industry will

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object. But they won't have the merits on their side. This subsidy to homeownership is neither economically efficient nor particularly equitable.

Economists have long pointed out that tax subsidies to housing, together with the high taxes on corporations, cause too much of the economy's capital stock to be tied up in residential structures and too little in corporate capital. This misallocation of resources results in lower productivity and reduced real wages.

Moreover, there is nothing particularly ignoble about renting that deserves the scorn of the tax code. But let's face it: subsidizing homeowners is the same as penalizing renters. In the end, someone has to pick up the tab.

There are certain tax expenditures that I like. My personal favorite is the deduction for charitable giving. It encourages philanthropy and, thus, private rather than governmental solutions to society's problems.

But I know that solving the long-term fiscal problem won't be easy. Everyone will have to give a little, and perhaps even more than a little. I am willing to give up my favorite tax expenditure if everyone else is willing to give up theirs.

The Bowles-Simpson proposal is not perfect, but it is far better than the status quo. The question ahead is whether we can get Senator Porkbelly and Congressman Blowhard to agree.

Source: New York Times, November 21, 2010.

case study Who Pays the Corporate Income Tax? The corporate income tax provides a good example of the importance of tax incidence for tax policy. The corporate tax is popular among voters. After all, corporations are not people. Voters are always eager to have their taxes reduced and have some impersonal corporation pick up the tab. But before deciding that the corporate income tax is a good way for the government to raise revenue, we should consider who bears the burden of the corporate tax. This is a difficult question on which

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economists disagree, but one thing is certain: People pay all taxes. When the government levies a tax on a corporation, the corporation is more like a tax collector than a taxpayer. The burden of the tax ultimately falls on people—the owners, customers, or workers of the corporation.

Many economists believe that workers and customers bear much of the burden of the corporate income tax. To see why, consider an example. Suppose that the U.S. government decides to raise the tax on the income earned by car companies. At first, this tax hurts the owners of the car companies, who receive less profit. But over time, these owners will respond to the tax. Because producing cars is less profitable, they invest less in building new car factories. Instead, they invest their wealth in other ways—for example, by buying larger houses or by building factories in other industries or other countries. With fewer car factories, the supply of cars declines, as does the demand for au to workers. Thus, a tax on corporations making cars causes the price of cars to rise and the wages of autoworkers to fall.

The corporate income tax shows how dangerous the flypaper theory of tax incidence can be. The corporate income tax is popular in part because it appears to be paid by rich corporations. Yet those who bear the ultimate burden of the tax—the customers and workers of corporations—are often not rich. If the true incidence of the corporate tax were more widely known, this tax might be less popular among voters.

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