Incidence of taxes

Originally published in the NTA Encyclopedia of Taxation and Tax Policy, Second Edition, edited by Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle. The encyclopedia is available in paperback from the Urban Institute Press. Order online at www.uipress.org or call toll-free 1-877-847-7377

George R. Zodrow
Rice University

The analysis and measurement of who bears the final burden of a tax.

One of the most fundamental questions in public finance is who bears the final burden of a tax. Calculating tax incidence is complex because tax-induced changes in individual and firm behavior and the associated changes in commodity prices and factor returns often imply that the final burden or "economic incidence" of a tax will be different from its "statutory incidence"-that is, once markets adjust, a tax may be partially or fully "shifted" from one set of economic agents to another. Business taxes are a frequently cited example, as they may be either "shifted forward" as higher consumer prices or "shifted backward" as lower wages or land prices. The tax incidence literature provides many insights and has played a critical role in the development of tax policy (McLure and Zodrow 1994).

Public finance economists have used three basic approaches to analyze tax incidence. One method analyzes the effects of taxes in theoretical models of the economy; these analytical models differ in many dimensions, including the number of markets analyzed, the extent to which factor supplies are assumed to be fixed, the method of capital accumulation, the nature of market competition, and the extent to which transitional issues are addressed. The second closely related approach involves numerical simulations of tax incidence in computer-based models that are basically complex variants of the analytical models described above. Finally, some incidence studies estimate individual tax burdens directly using large microdata sets. All of these approaches have become in- creasingly sophisticated over time, and several excellent surveys of the incidence literature, which examine in detail the various types of models outlined below, have appeared over the years (Mieszkowski 1969; Break 1974; McLure 1975; Kotlikoff and Summers 1987; Atkinson 1994; Fullerton and Metcalf 2002).

Partial-equilibrium analysis

The simplest type of incidence analysis examines the impact of a tax in a "partial equilibrium" framework-that is, within the context of a single market, neglecting any tax-induced effects on other markets. Although relevant only when such effects can reasonably be assumed to be unimportant, partialequilibrium models provide many insights. Most important, they demonstrate that incidence is determined primarily by the extent to which individuals or firms are able to change their behavior to avoid the tax. For example, the burden of an excise tax tends to be borne by consumers if demand is relatively inelastic and by producers if supply is fairly inelastic; indeed, if supply is perfectly elastic (as is the case with constant returns to scale in production) or demand is perfectly inelastic, consumers bear the entire burden of an excise tax. In addition, these same factors determine who bears the excess burden of a tax-the efficiency cost attributable to tax-induced distortions of individual and firm behavior. Finally, partialequilibrium analysis can be used to demonstrate another basic tenet of incidence analysis-that the economic incidence of a tax in a competitive system depends solely on market conditions and is independent of its statutory incidence.

Nevertheless, partial-equilibrium analysis is limited in that most taxes have important effects on markets other than the ones in which they are assessed. Moreover, the focus in partialequilibrium models on incidence in terms of producers and consumers is unsatisfactory, as one would like to identify explicitly the factor owners who bear the producer portion of the tax burden and the types of consumers that are affected by tax-induced commodity price changes.

Static general-equilibrium analysis

These two problems are resolved in general-equilibrium models of tax incidence. Such models account explicitly for market interactions by calculating the effects of tax-induced factor reallocations on all other markets in the economy. In addition, the effects of tax changes on individuals can be determined explicitly by specifying individual tastes and patterns of factor ownership and calculating the welfare changes (typically equivalent variations, including excess burdens) associated with various tax reforms.

The simplest general-equilibrium models are "static," in that total factor supplies are assumed to be fixed. Much of this research is based on the seminal article by Harberger (1962), which built on Musgrave (1953, 1959). The Harberger model assumes perfectly competitive markets and zero initial taxes and has a single consumer, two production sectors, and two factors of production-capital and labor-that are perfectly mobile between the sectors, although fixed in total supply. The model is thus ideally suited to analyzing the intermediate-run effects of sector-specific taxes; it was initially used to examine the incidence of the corporate income tax, with the two production sectors representing corporate and noncorporate output.

The primary insight obtained from such models is that general-equilibrium effects in markets other than those in which a tax is introduced are often very important in determining the incidence of a tax. For example, the imposition of a partial factor tax drives the factor out of the taxed sector into the untaxed sector, tending to depress the overall return to the factor. (Note that the assumption of intersectoral mobility implies that the burden on any factor is shared among all factor owners rather than just the owners of the factor in the taxed sector.) Incidence results in such models are almost always theoretically ambiguous, but numerical calculations can shed some light on the range of reasonable outcomes. For example, Harberger argued that, for plausible parameter values, capital owners bear the full burden of the corporate income tax on equity income, a result that was generally confirmed in subsequent numerical simulation models (Shoven 1976).

The static general-equilibrium model has also been used to argue that the property tax is primarily a tax on capital, because capital owners bear the average burden of property taxation in the nation, while tax differentials across jurisdictions cause higher commodity prices and lower factor returns in relatively high tax jurisdictions and the opposite effects in relatively low tax jurisdictions (Mieszkowski 1972; Zodrow and Mieszkowski 1986). This view has been challenged, however, by those who argue that the property tax, when combined with the appropriate zoning restrictions or by perfect capitalization of fiscal differentials in land prices, is effectively a benefit tax for local public services (Hamilton 1975, 1976). This issue, critical to an understanding of state and local public finance, is still controversial (Fischel 2001; Zodrow 2001).

The two-sector static general-equilibrium model has the significant advantage of being simple enough to be solved analytically for the factors that determine incidence as well as the parameters that establish their magnitudes. For example, the effect of the corporate income tax on the return to capital in the Harberger model can be decomposed into two components (Mieszkowski 1967). The first is a "substitution effect," which reflects reduced demand for capital in the taxed corporate sector and has an unambiguously negative effect on the return to capital. The second is an "output effect," which reflects reduced demand for corporate output because of its tax-induced increase in price; the output effect has a negative (positive) effect on the return to capital if the taxed sector is capital (labor) intensive, as the reallocation of production from the taxed to the untaxed sector implies an excess supply of capital (labor), which must be eliminated by a reduction in its relative price. Such results are typical of analytical general-equilibrium models, with commodity demand elasticities, consumption shares, factor intensities, and elasticities of substitution in production among the critical factors that determine the magnitudes of general-equilibrium tax incidence effects.

The basic analytical static general-equilibrium model constructed by Harberger has been extended in a wide variety of ways. One extension allows consumers with different tastes, in which case income redistribution affects consumer demands and thus relative consumer and factor prices and net incomes (Mieszkowski 1967). The assumption of perfect factor mobility has also been relaxed, in which case the burden of taxes tends to fall on relatively immobile factors (McLure 1970, 1971). The assumption of perfect competition has been questioned, especially for analysis of the corporate tax. Although no widely accepted model of imperfect competition exists, these models tend to be characterized by more forward shifting of taxes to consumers than occurs under perfect competition (Katz and Rosen 1985; Anderson, de Palma, and Kreider 2001).

The basic static general-equilibrium model has also been used to analyze tax incidence in open economies, in which case one sector represents a small open economy and the second sector represents the rest of the world (or country, in the case of a state or regional analysis). In the simplest cases, the main result is that, although capital still tends to bear the overall burden of a tax on capital in the small taxing jurisdiction, the outflow of capital caused by the tax lowers returns to immobile factors in the jurisdiction by the sum of the tax and its excess burden (Brown 1924; Bradford 1978). The policy implication is that small open economies facing a perfectly elastic supply of a factor should not tax that factor (Gordon 1986; Slemrod 1988). More generally, increasing international mobility of capital suggests that open economy considerations should play an important role in tax incidence analyses, although the extent and implications of international capital mobility are still controversial (Harberger 1980; Feldstein and Bacchetta 1991; Gravelle and Smetters 2001; Ballard, 2002).

Finally, because the Harberger model assumes that initial taxes are zero, excess burden effects cannot be analyzed because they are second-order effects and thus do not appear in a differential analysis. The extension to an existing tax structure allows explicit analysis of the burden of the efficiency costs of taxation (Ballentine and Eris 1975; Vandendorpe and Friedlaender 1976); such models are essential for the analysis of the incidence of tax reforms (Feldstein 1976; Zodrow 1981, 1985).

A key problem associated with the analytical studies described above is that the number of markets and consumers must be severely limited to keep the models tractable. This problem has been attacked by utilizing the basic structure of the Harberger model in the construction of large-scale computable general-equilibrium models that analyze tax incidence in economies with many production sectors, types of assets, and types of consumers (Ballard et al. 1985; Jorgenson and Wilcoxen 2002). In addition, these numerical models have been extended to include considerations of risk and endogenous financial behavior (Slemrod 1983; Galper, Lucke, and Toder 1988).

Dynamic general-equilibrium analysis

The primary problem with the static analyses described above is that tax effects on total factor supplies are ignored; in particular, many observers have argued that this assumption is unreasonable when the incidence of a tax is borne by capital owners (although similar points could be made regarding the supply of labor and the stock of human capital). The following discussion outlines several approaches used in analyzing tax incidence from a dynamic perspective.

Early analyses of dynamic tax incidence focused on adding taxes to the neoclassical growth model. In this case, capital income taxation reduces saving, which in turn lowers the equilibrium capital-labor ratio; as a result, labor productivity falls and wages decline, implying that the tax has been at least partially shifted from capital to labor. Indeed, in the special case in which capital owners save all their income and workers save none, the burden of a capital income tax is fully shifted to labor; more generally, the extent of shifting varies from about one-third to one-half (Krzyzaniak 1967; Feldstein 1974), although reaching the new equilibrium may take considerable time (Boadway 1979).

More recent analyses of dynamic tax incidence have modeled individual saving and investment decisions explicitly, within the context of either infinite horizon models or, more commonly, overlapping-generations life-cycle models. The former approach assumes perfect foresight by one or more types of optimizing infinitely-lived individuals. These analyses stress the long-run effects of capital taxes on capital accumulation and typically calculate the incidence of reforms as the equivalent variations, expressed in present value terms, experienced by suppliers of labor and by capitalists (Judd 1985).

In contrast, overlapping-generations life-cycle models stress that the effects of taxes on capital accumulation depend on their relative effects on individuals at different stages of their life cycles, and calculate the differential incidence of tax reforms across the various generations alive at the time of reform as well as on future generations. For example, under a switch from an income tax to a cash-flow consumption tax, double taxation of existing assets results in a large welfare loss to the elderly, which in turn implies lower steady-state tax rates; by comparison, a switch to a wage tax confers a windfall gain to the elderly (who expected to be taxed on the income earned by their capital assets) and implies relatively higher steady-state tax rates (Summers 1981a; Auerbach and Kotlikoff 1987; Altig et al. 2001; Zodrow 2002).

Finally, both the static and dynamic analyses described above assume that capital reallocations are instantaneous and costless; however, in the presence of adjustment costs, tax incidence analysis must consider tax-induced changes in asset prices (Summers 1981b). Such asset price changes measure the windfall gains and losses attributable to the enactment of tax reforms and, if the adjustment period is long, may be a more important determinant of incidence than the long-run changes in factor prices stressed in most analyses. Moreover, the nature of such windfall gains and losses may be surprising. For example, the enactment of an investment incentive that applies only to a new investment is likely to result in a loss to the owners of existing capital assets; equilibrium returns, which accrue to both new and old capital, will decline because they are determined by the tax treatment of new investment, and these lower returns will be capitalized as lower values of existing assets (Auerbach and Kotlikoff 1983).

Empirical incidence analysis

Another approach to determining tax incidence uses microdata sets to estimate individual tax burdens and thus estimate their distribution across individuals. These studies draw on the theoretical and empirical literatures to make assumptions about the incidence of various taxes and typically include calculations for a variety of incidence assumptions. Such studies have generally found-depending on the incidence assumptions made, especially regarding the corporate income tax and property taxes-that the combined federal, state, and local tax structure in the United States is either modestly progressive or modestly regressive and roughly proportional over a wide income range (Pechman and Okner 1974; Pechman 1985). The aggregation of all taxes, however, masks the progressivity of the federal income tax; one recent study estimates that the average effective individual income tax rate for a married couple filing jointly with two children varies from -40 percent at an adjusted gross income (AGI) of $10,000 (due to various refundable credits), to 8.4 percent at an AGI of $100,000, to nearly 24 percent for households with an AGI of $1,000,000 (Burman and Saleem 2004).

Such studies have often played an important role in tax reform debates; for example, their basic methodology was used by the U.S. Treasury in determining whether the various reform proposals considered before passage of the Tax Reform Act of 1986 satisfied the constraint of "distributional neutrality" (McLure and Zodrow 1987). Nevertheless, they have been criticized on a number of grounds. Although many critiques focus on the specific incidence assumptions used to allocate tax burdens across income classes (Joint Committee on Taxation 1993), another critical issue is the use of annual income as a classifier. Many observers have argued that lifetime income is a better measure of ability to pay taxes, and that the distribution of tax burden should be measured by comparing lifetime income and taxes. Such calculations generally indicate that consumption taxes are less regressive and income taxes less progressive than do studies based on annual income (Davies, St-Hilaire, and Whalley 1984; Poterba 1989; Casperson and Metcalf 1994; Fullerton and Rogers 1993). The lifetime approach to tax incidence analysis is, however, by no means universally accepted (Barthold 1993; Reschovsky 1998).

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