The taxing issue of burden

One thing I have noticed of late is that many people want to talk about tax cuts in terms of “who gets what”.  We see someone with an income of $XXX and say they will get $Y a week from the tax cut.  I find this perplexing as I have never seen tax this way.

The reason why I find this way of looking at tax changes strange is that it ignores how prices change in response to the structure of the tax system.  I fear that, to many people, this seems like a benign (possibly even esoteric) issue – when actually it is one of the most essential issues to keep in mind when thinking about the design of a tax system.

Partial equilibrium

The first step required to analyse this is our good friend the “economic scissors” – or supply and demand.  The introduction of a tax creates a “wedge” between our supply and demand curves, which in turn implies that the quantity produced in the industry is lower, and the prices faced by the supplier and the purchaser are different.

Now in the case of the labour market, the purchaser is a firm and the suppliers are workers.  Only by looking at how responsive supply and demand are to changes in the “price” (wages)  can we infer what will happen when we change the tax rate – both to the welfare of the individuals in the market and the output produced in the market.

Update:  Eric Crampton discusses experimental evidence that shows where people struggle with this concept.

General equilibrium

However, our scissors only take us so far.  The labour market is not independent of other markets out in society.  A higher tax in the labour market implies that input costs are higher in the goods market – a factor that influences prices and output.  Furthermore, lower production in the labour market implies just that – lower production/output.

Given the general nature of a tax on all labour income, and given the fact that labour is an input, it is not really clear exactly how a tax on one group will impact on everyone is society.  It is possible to say that, although a tax on the wealthy which redistributes will make the poor relatively better off – it may also make them worse off in an absolute sense [note, this is not inconsistent with the second welfare theorem as a labour tax has a supply side impact that a “redistribution of endowments” does not].  Now I don’t believe that we are near a stage where this is the case – but it does illustrate that the idea of redistribution is inherently fraught with complications.

Time path

Furthermore, the welfare costs of the transition between different tax systems are inherently difficult to understand.  Saying that so-and-so gets a $Y a week tax cut may be true in that very moment of time – but within a year the path of prices in the goods market, the negotiation of wages in the labour market, and the path of government spending will all have likely changed relative to their pre-tax cut level.

As a result, how this transition functions has costs and benefits in of itself – which is also an important issue to understand.

Conclusion

As we have described above, the issue of “redistribution” through “labour tax” is unclear.  This is one of the primary reasons why economists like the idea of a “flat tax” – since the redistributive impact of progressive taxation in itself is unclear.

If we combine a flat tax system with a targeted benefit system (which is based on both extensive research and an exploration of societies preference for redistribution) we have a clear and transparent equity-efficiency trade-off.  This seems like an appropriate way of forming, and then fulfilling, our social contract.

However, the same people complaining about the $Y a week so-and-so gets would criticise such a shift to a flat tax system on the same grounds.  Hopefully, by pointing out that such a static view of tax changes doesn’t make sense we can help put the desires for a more transparent tax system in context.

  • Nobody understands even first round tax incidence, never mind GE. You’ve seen the Tyran and Sausgrubber experiments on tax incidence, right?

  • @Eric Crampton

    “Nobody understands even first round tax incidence, never mind GE”

    I would hope that 7th form (sorry Year 13) and 1st year economics students understand tax incidence – they have to make up a fair chunk of the population right?

    “You’ve seen the Tyran and Sausgrubber experiments on tax incidence, right?”

    No I haven’t. But you have piqued my interest – link?

  • It’s linked here, but since you don’t know the piece, it’s probably worth my posting on more generally…hold 5 minutes…

  • @Eric Crampton

    Excellent!

  • Ok, I admit it. I’m having trouble getting my head around this post.

    Basically you’re arguing that Paul Reynolds’ going to take a pay cut (or less of an increase) due to paying lower taxes, and my broadband bill is going to go down?

  • @Chris Baxter

    Here:

    http://www.tvhe.co.nz/2010/02/19/a-150000-pay-increase/

    The key point is that Paul Reynold’s salary is set given the wage rate, and given Telecom’s ability to charge and produce. If the taxation on his work is lower the “benefit” of this is shared between him, the firm, and the consumer of the service depending on how prices in the economy eventually adjust.

    In the post I’ve linked to I think I argue that, starting with the “partial eqm” idea most of the benefit goes to Telecom, not Paul, in the end. If we take this a step further back it implies that Telecom’s rate of return is higher, and so it will attract more investment, blah blah blah.

    Ultimately, I don’t have a model sitting here to analyse this sort of case – and it is a complicated issue to try to analyse … VERY complicated. However, we can say that when prices are adjusting a lot of the “benefit” of that tax cut will actually accrue to people who are not Paul.

    This is the thing with taxes – we often just don’t know where the final incidence will fall. Saying that so-and-so gets $Y from a tax cut assumes that the incidence of the tax has (previously) fully fallen on them – which is a very very extreme assumption.

  • Daniel Twaddle

    Hi Matt.

    I haven’t read the whole post but I think I get the drift. First, you ARE right. But does that mean that most people should stop thinking in their simplistic way about tax cuts? Should the media really bother trying to explain things when even you admit that you don’t know what the outcomes will be and that you would need a super fancy model to estimate (let alone understand) them? For most people I reckon that its more efficient to just understand the slightly inaccurate “I get $Y” than to struggle with these concepts.

    The reason for this is that there is a cost to trying to understand the points that you make. For most people, putting in the effort to stop their eyes glazing over as you explain all this will need for the difference between the ‘real’ impact of the tax cuts (your type of analysis) and their own stylised understanind of its impact (“how much more $$$ a week do I get”) to be material enough that the benefits of understanding to outweigh the costs. Otherwise “how much do I get” is about as much explanation as they should be seeking.

    There are at least two reasons why the practical difference between the ‘real’ impact of the tax cut and peoples stylised understanding is unlikely to be that great (or rather, great enough to make it worthwile to bother understanding the difference):

    (1) The first reason is that the GE impacts (and even the partial equilibrium impacts) are not likely to be HUGE and many will cancel out (so as a made up examplel, maybe instead of getting say $10 a week more once these impacts work their way through, they will instead actually get $10 +-$2.50); and (2) there will be some stickiness in the transmission of the impacts

    (2) The second reason is that these impacts will take some time to work their way through, ie stickiness in adjustments. People’s take home pay will change immediately as the tax cuts go through, the other impacts that you so accurately describe will take a while to sort themselves out. In reality, 5-10 years (but thats just a guess) for most to be felt. People’s time preferences are pretty biased towards the present, further reducing the impact of these adjustments through time.

    In a nutshell, it is inaccurate to portray things as a simple “how much does each person get” way. But if you Matt Nolan can’t tell us exactly what the difference will be in a paragraph, I wouldn’t expect the Treasury to have the faintest understanding of these concepts, let alone the media or general public. And for the reasons above, in practical terms I don’t think that the difference is going to be big enough to stress their minds with (very arrogant, I’m sorry!).

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  • @Daniel Twaddle

    Hi Dan,

    In this case I completely disagree. Namely with this:

    “The first reason is that the GE impacts (and even the partial equilibrium impacts) are not likely to be HUGE and many will cancel out”

    This is something I’ve heard, constantly, from policy analysts in the past. For some reason, many analysts have this impression that a few % points of tax won’t do anything – yet a quarter of a % point change in the OCR will have a massive impact … this is wildly inconsistent.

    For example, when Labour was in power many people felt the difference between 39% and 33% was inconsequential – however, when you frame it as a choice (by moving money into trusts) and recognise that the choice of tax regime offers a risk-free rate of return (on top of other returns) of 8% it becomes obvious that it does matter a lot 😀

    I wouldn’t say this type of logical has all too much to do with fancy models. It is pretty easy to think about the elasticity of supply and demand and talk about price responses with only a faint understanding of economic – hell, I can remember going over this stuff in secondary school. Even if we were to randomly assume that GE considerations were small this fundamental point makes the idea of “so-and-so gets $Y a week” patently false.

    Now, if someone was to say – this tax cut will lead to “such-and-such a part of the labour market increasing the value of current transactions by $Y a week” that would be an improvement. And by just doing this, we would have a better discussion on tax policy.

    However, tax policy IS a major structural issue. In order to determine what is good policy we SHOULD create large models and accurate simulations to understand the trade-offs inherent in the policies. This fact makes politics based on the “so-and-so gets $Y a week” type statements even more abhorrent IMO.

    Also – I agree on the time path argument, as I mentioned it in the post under a subheading. However, the initial adjustment will be A LOT less than 5-10 years – successful wage demands will change IMMEDIATELY, leading to a significant impact within a year. Previous changes to the tax system have shown this.

    “But if you Matt Nolan can’t tell us exactly what the difference will be in a paragraph, I wouldn’t expect the Treasury to have the faintest understanding of these concepts, let alone the media or general public”

    So it is ok to blatantly mislead people if you can’t give them a complete model of the economy in one paragraph – this is why I don’t work for government 😀

    My paragraph of explanation would only focus on the tax incidence argument (as that is the easy one, which provides a lot of understanding). I would say:

    People are willing to work given their post-tax wage and people are willing to hire workers on the basis of their pre-tax wage. When we cut taxes, the gap between these two is lower – so in a specific industry if we cut taxes wages, and the amount of people hired, will change in a way that depends on the relative makeup of that industry.

  • Daniel Twaddle

    @Matt. “I completely disagree”. Thems fighting words! Kidding. But my thoughts:

    “However, tax policy IS a major structural issue. In order to determine what is good policy we SHOULD create large models and accurate simulations to understand the trade-offs inherent in the policies.”
    – I absolutely agree. That is why you SHOULD go and work at the Treasury and kick some arse :-P. But if they don’t understand this stuff there at the moment, it is kinda hard to expect the media and general public to be on top of it all. That isn’t to say that it is right that things are this way, but until you go there and clean their house up don’t expect any better from the media.

    “Now, if someone was to say – this tax cut will lead to “such-and-such a part of the labour market increasing the value of current transactions by $Y a week” that would be an improvement. And by just doing this, we would have a better discussion on tax policy”
    – Okay thats a fair point. I’m with you on that.

    My difference in opinion with you mainly relates, I think, to what people actually want to know when the budget tax cuts are reported, and thus whether “$Y a week” is useful or not (now, for the record I also find it abhorrent to put things this way, but that is just my inner pedant coming through :p). Now, IF people are interested in the macro-economic effects for society generally, “$Y a week” is not useful. You explained why very well. But, despite wishing it weren’t so, it is my contention that people just want to know how much more/less goods and services they will be able to pay with their take home pay for the next year or two as a result of the tax package. And I stand by my comments that “Y per week” will more or less be a good rough approximation. Of course, within 2-3 years macro effects etc will come into play taking on a bigger and bigger role, but by then the average dompost reader just isn’t that interested. But if he was interested, there are some interesting questions for how you would do the long term modelling that you would need to explain to him. Assuming we go from a balanced budget and cut taxes, how are we going to fund that? Future tax hikes? Smaller government sector despite promises not to cut services? Big calls second guessing government policy (and in all likelihood there is no government policy on this) are needed. As the average readers eyes glaze over, I can understand why Treasury backs away from doing this (without agreeing with it).

    So I don’t think that it is worth it for the average reader, sadly. It wouldn’t sell newspapers. But I agree the modelling should be done and there is a huge gap there in terms of the quality of the policy advice that is underpinning government decisions.

  • Daniel Twaddle

    Haha, I should read your entire post before commenting… makes more sense now..

  • @Daniel Twaddle

    “Them’s fighting words!”

    😀

    That is how I roll 😉

    “But if they don’t understand this stuff there at the moment, it is kinda hard to expect the media and general public to be on top of it all”

    I think Treasury completely understands it – I just don’t think that these matters are appropriately discussed in public discourse and so the issue has been framed in a poor way 🙁

    “And I stand by my comments that “Y per week” will more or less be a good rough approximation. Of course, within 2-3 years macro effects etc will come into play taking on a bigger and bigger role, but by then the average dompost reader just isn’t that interested”

    While I do not disagree that the immediate impact will be on the wage of those currently working, wage negotiations and the movement between jobs will happen such that the incidence argument will become essential in a much smaller time frame. I guess with this specific point we are just attributing different beliefs to the level of wage stickiness in the economy.

    “So I don’t think that it is worth it for the average reader, sadly. It wouldn’t sell newspapers.”

    Yar, hence why I wanted to raise the point here – even though no-one will read it 😉

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  • @Matt Nolan
    A few points, firstly, I think that the reason the media has not focused on on framing the issue in this was is that is sounds awefully like “trickle down effect”, which has rightfully become a dirty word over the past 25 years.

    Secondly, you’re arguing that much of the drop in the top tax bracket will be absorbed by the employing company, therefore, presumably lowering the total tax burden on said company. Here you’re arguing that this will have major flow-on effects to the market, but previously you’ve argued that “whatever investment turns up on the basis of a slight cut in corporate taxes will only be a very marginally profitable investment opportunity”. How do you reconcile these two positions?

    Thirdly, “successful wage demands will change IMMEDIATELY, leading to a significant impact within a year. Previous changes to the tax system have shown this.”
    I’d be really interested to see the evidence for this.

    cheers

  • @Chris Baxter

    Hi Chris,

    “A few points, firstly, I think that the reason the media has not focused on on framing the issue in this was is that is sounds awefully like “trickle down effect”, which has rightfully become a dirty word over the past 25 years.”

    It is nothing like trickle down though – and it is also an accurate representation of how a tax works.

    The problem is that, they talk about a tax cut like they are giving individuals money – but they ignore the fact that a tax cut is just the reverse of a tax increase, and we should use the same tools and logic to understand them. It is a framing problem.

    “Here you’re arguing that this will have major flow-on effects to the market”

    My main point was that, by lowering input costs some of this surplus will go on to consumers – not that therre would be significant indirect effects. In essence, the firm combines with labour to sell things to consumers – so if we change taxes in one part of this, the outcomes change for all groups.

    “Here you’re arguing that this will have major flow-on effects to the market, but previously you’ve argued that “whatever investment turns up on the basis of a slight cut in corporate taxes will only be a very marginally profitable investment opportunity”. How do you reconcile these two positions?”

    Firstly, corporate tax is on profits – income tax is on all income revenue, so corporate tax changes are a lot more marginal.

    Secondly, when I stated “marginal” I was actually discussing the attractiveness of NZ as a destination for capital, not the end change in domestic investment resulting from the tax change – my argument was against us need to change the capital tax to meet the Aussies, not against a lower capital tax persee.

    I do agree that a lower capital tax will lead to higher investment and the such – but this justification is one we should use for lowering the tax because we want higher investment NOT because we feel we have to follow Australia around.

    “Thirdly, “successful wage demands will change IMMEDIATELY, leading to a significant impact within a year. Previous changes to the tax system have shown this.””

    Ask firms what sort of wage increases they are willing to give following a tax cut – ask workers if they can understand why the firm will give them a lower increase in wages following a tax cut. I can say that talking to firms has illustrated that they aim to give lower wage increases on this basis for sure.

    Furthermore, during the 1980s one of the justification for tax cuts was that they were disinflationary – given that higher post-tax wages would lead to lower wage demands. I can’t see to find a wage series that goes back far enough to test this – but it was a common view at the time when major tax changes were being put in place.

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  • coolblog

    Indirect taxes do raise prices and direct taxes do reduce income. Therefore, the government should weigh the benefits against the drawbacks of introducing changes in any tax system. http://mbamanagementonline.com/