Friday, January 8, 2010

Intuitive Explanation of Who Pays the Tax

Non-intuitive explanation
When a tax is levied against a transaction, both parties to the transaction end up bearing some of the burden of the tax. Whether the buyer or the seller pays more of the tax depends on who has the greater elasticity.

Intuitive explanation
If I want to buy a new boat, but the government just put a new luxury tax on boats, will the boat dealer be able to pass the tax along to me or will he be forced to eat the tax? It depends on who wants to do the deal the most. Of course the seller will do his best to pass the tax on to me, but if he’s desperate to sell boats, and so are his competitors who are also trying to sell me a boat, then he’ll lower his price to get me to buy – effectively eating the tax himself.

It doesn’t matter who officially pays the tax. For example, officially I pay my income tax. But in a tight labor market (when there are lots of jobs and companies are having a hard time finding enough employees), my employer might be the one who is effectively paying the tax. Let’s say that I’m working for a company during a time when employers are desperate to hire people, and the government increases the income tax. My current employer doesn’t automatically raise my salary to compensate me for the increased taxes, so he’s effectively forcing me to eat the tax. However, if another company offers me a position doing the same kind of work for more money, then I can either take the new job, or try to extract a raise out of my current employer. In that kind of market I can effectively force the cost of the tax onto either my old employer or my new employer, because they need me worse than I need them.


  1. Great blog! But I don't think I'm your core audience, and so I have a lot questions about this post. I hope you don't mind if I jump right into it.

    "When a tax is levied..." meaning what kind of tax? Is this sales tax, or is it broader than that?

    "Pass the tax along" means raising the cost, correct? And "eat the tax" is selling something at a loss?

    Also, I'm nearly completely lost on who officially or effectively pays the tax.

    For those of us who are tax-dense, this explanation is not very intuitive. Would you mind clarifying?

  2. Anonymous,

    Thanks for the questions, and sorry I wasn't more clear. I guess I failed in my attempt to give an intuitive explanation!

    In this post I'm talking about taxes on voluntary transactions, e.g. when something is bought/sold. If I sell you my car, then we both have to agree to the transaction or it doesn't take place. That's the kind of transaction I'm talking about, and I'm not including things like inheritance because with inheritance I don't get to choose whether I die. Essentially, I'm forced into that transaction (even though I don't have to leave my money to YOU, it does have to go to somebody or some institution).

    So, think about the two most common transactions that most of us engage in each day: 1) buying goods and services, and 2) selling our labor to an employer. Both of those two kinds of transactions are taxed, and the government periodically adjusts the tax rate.

    You're right that when the seller passes the tax along to the buyer, the seller does that by raising the price. If the seller eats the tax, then the tax is coming out of the seller's profit margin. The seller could still be making a profit, just not as big of a profit.

    As to who officially pays the tax, think about who literally sends the money to the government. Sales tax is usually sent to the government by the seller, so you could say that the seller is the one who officially pays the tax. Income tax is officially paid by the seller also. If I'm a wage-earner, then officially I pay my income tax when I prepare my tax return and mail it in.

    However, I argue in the post that it doesn't matter who mails the check to the government, but that what we care about is who gives up value. Is the seller forced to lose some profit, or is the buyer forced to pay a higher price? That's the real question.

    I hope this helps!