Tax incidence: lawyers versus economists

Tax lawyer and advisor to various advocacy groups like the Tax Justice Network and Action Aid, David Quentin, wrote a blog that exposes the gulf between economists and lawyers when it comes to tax incidence. My reaction on Twitter confused him, so at David’s request, and for anybody else interested, here’s an explanation.

Companies are legal persons … this means that … prima facie it is the company itself which bears the economic burden of [tax] payment. When economists talk about which category of person the “incidence” of corporation tax falls on, however, it is always either shareholders or workers or some other category of person aside from the company itself. As a lawyer this makes no sense to me. Clearly the incidence of a tax doesn’t necessarily fall on the person whose legal obligation it is to pay it, but why should that mean that it must fall somewhere else?

If corporation taxes have no incidence aside from the legal person of the company itself you have found a magic money tree — a way of raising taxes without burdening any human beings! As an economist, that makes no sense to me.

When popular commentators address this question they usually say something like “the incidence can’t fall on the company because the company isn’t a real person; it is a legal fiction” but they never go on to explain why the fact of not being a human means that a legal person owning its own assets beneficially for itself can’t bear a tax burden.

Things happen to non-persons all the time. Football clubs get relegated, elves kill orcs inside computer game servers. When economists say tax incidence cannot fall on a company, it might be better to say that we only care about things that happen to non-people to the extent that they affect real people. This may come as a shock to some, but mainstream economics is all about the welfare of people.

Of course it is true that the company making a payment of tax will consequently have less money available for other stuff (dividends; salaries; whatever) …

Well there you go. All that other stuff affects people. But as ever with economics, rather than just stopping at “company that pays £100 tax now has £100 less for other stuff” you have to think about how behaviour responds to the tax. For example, in theory the incidence of corporation tax upon workers is a second-round effect as, over time, taxes cause the level of investment in the economy to be lower than it would be in the absence of the tax, and that affects prevailing wages. In the short run, holding the capital stock constant, the incidence of a corporation tax increase would look different. In theory, again, firms cannot just cut wage when profits are taxed because they have to pay the going rate to attract and retain workers (although in reality firms do have some wage-setting power and I recall seeing pretty good empirical evidence there is some direct pass-through to wages). As an aside, I am always puzzled why some people seem are so quick to accept tax incidence falls outside the firm in the case of VAT yet seem resistant to the possibility with other taxes.

What we are talking about is therefore not strictly tax “incidence” as such but the quite different and much broader question of a tax’s (necessarily indirect) economic impact upon a group of people arbitrarily defined to exclude the person actually paying it.

I am afraid I rather lost the thread of the passage the excerpt above is taken from, but there is nothing arbitrary about analysing taxation in terms of the ultimate impact it has on flesh and blood human beings.

That being the case, the question “upon whom does the ‘incidence’ of corporate tax fall?” is using economics jargon to perform a rhetorical sleight of hand, asking only a narrow portion of the true question in order to yield a misleading answer.

Whoa there! There is no sleight of hand, nobody is being misled. A government wishing to raise a given sum of revenue can do so via different taxes, and economists quite rightly ask who is made worse-off under each choice. That’s all tax incidence means, and it is a fundamental element of tax policy.

The other portion of the question that is really being asked (if it is to be carved up in that way) is “who bears the economic burden of corporate profits insofar as they arise untaxed?”

No, that’s a different question. Profits exist in the economy, and we may ask who bears the burden of, and who benefits from, profit. Separate question: who bears the burden if we then try to tax those profits?

Sadly, economics does not offer any sort of consensus on the question of where corporate profits come from, so it has nothing to say about this other four fifths of the (so-called) corporate tax “incidence” question.

What the what? I do not know where David acquired his opinions about economics, but he needs a better source. In a first-round fashion, the incidence of profit falls on the customer, in the sense that there is a zero-sum between producer surplus and consumer surplus. The source of profit is pricing power and economics has a lot to say about where pricing power can come from. Economists use a term “rents” to refer to excess profits, and one justification for corporation tax is that it is way of taxing rents. Incidentally, it would be a mistake to think that profits are all bad — profits are the (main) motivation for investment, so we’d all be worse-off if profits were zero.

One thing is quite clear, though; the economic burden of untaxed corporate profits is absolutely not borne by shareholders; on the contrary, shareholders are the people who stand to benefit from untaxed corporate profits. So if anyone tells you that corporate tax is regressive because its “incidence” falls on workers, they are talking a steaming load of old (ahem) nonsense, based on a rhetorical sleight of hand.

First, regressive means something like “falls on workers more than it falls on shareholders”; saying there is some incidence of corporation taxes on workers is a weaker claim than that. Secondly, but more importantly, the extent to which corporation taxes wind up making workers worse-off is an empirical question, it is not to be settled by reasoning, and the empirical evidence must be taken seriously. This is not rhetorical sleight of hand, but a well-defined and important question. At least that’s the economics, I can’t speak for the rhetoric of anti-tax advocates.

There is, of course, something we have not mentioned yet, and that is who benefits from the good things that taxation funds. And guess what, economists have a term for that too: benefit incidence. Tax economists, as exemplified by the Mirrlees review, emphasize that the tax and benefits system must be analysed as a whole. It is quite possible to say that corporation taxes have some incidence on workers, but that they come out ahead if the pattern of spending is sufficiently in their favour. It is also possible that despite corporation taxes having some incidence on workers, other ways of raising the required revenues would be worse for workers.

David is right to think that tax incidence is only part of the story, wrong to think that economist’s concern with real people is misguided, and wrong to think that other parts of the story — particularly the burden of excess profits — are absent from economics.