23
Apr
12

Tax incidence, motherfucker: Do you speak it?

It is standard practice in Canadian policy circles to assume that for the purposes of estimating the changes in revenues from a given tax measure, people will make exactly the same decisions as before, with the only difference being the difference in the amount of tax they pay. This assumption is made because it simplifies the analysis, not because anyone believes that it’s a reasonable assumption to make. All tax changes produce a behaviour response of some kind.

That’s Stephen Gordon tilting at the windmill of explaining tax incidence to the Globe and Mail‘s online readership, and incidentally supporting my authoritarian fantasy that — when the right people are in charge — everyone be required to take a differential calculus course (in particular: “change in a value with respect to time”) and demonstrate their retention of key concepts before being permitted to exercise their franchise.  He has an even better article up here:

Key point:

But high earners are different. There aren’t many of them, and they have market power that most workers do not. If their tax rates go up, they will try to leverage that bargaining power and obtain a salary increase that at least partially offsets the higher tax burden.

An extreme example of this sort of effect occurred when the UK government imposed a 50 per cent bonus ‘supertax’ on banks last year: banks simply doubled the size of the bonus pool so that after-tax bonuses would stay the same.

[...]

What becomes more problematic is just who will bear the burden of those taxes – or, in the language of public finance, what is the incidenceof increased income taxes on high earners? The ostensible targets of the UK bonus supertax were high-earning bank employees, and since they bore the statutory incidence of the supertax, they did indeed pay more taxes. But since they were able to obtain increases that left their after-tax incomes untouched, they weren’t left out of pocket by the measure: the economic incidence was passed on to shareholders, other employees and bank customers – in short, everyone except the original target. If the goal of the bonus supertax was to reduce the gap between high earners and the rest of the income distribution, it’s hard to see how it could be considered a success.

(Emphasis added.)

Now, tax incidence is a pretty important concept in general, but for the most part I linked to those two posts so that I could snark about this:

Ontario Premier Dalton McGuinty is making a major concession in a bid to save his minority Liberal government by agreeing to impose a new tax on the rich.

Those who earn more than $500,000 a year would be asked to pay a 2 per cent surtax, Mr. McGuinty announced at a news conference on Monday. The new tax would generate revenues of $470-million next year, all of which, he said, would be used to help reduce the deficit.

Don’t worry, Ontario: There’ll be plenty of jobs waiting for you in the oilpatch when your province goes the way of Michigan.


8 Responses to “Tax incidence, motherfucker: Do you speak it?”


  1. April 24, 2012 at 08:00

    Interesting, way that trickle-down economics are right. Since taxes on the rich hit (incide?) those further down the corporate totem pole, it follows that relieving taxes on the rich will (eventually) relieve taxes further down.

    (Similar things; the ‘employer’ half of social security comes out of employee compensation. As does health insurance, dollar for dollar.)

    I wonder if this is also an Ockham explanation of absurd CEO pay. Bonuses are already scaling with taxes.

    Penultimately, this is not political incompetence. They’re are indeed experts – at increasing their funding. By appearing to tax the rich, McGuinty’s staffers get to raise tax revenue from the not-rich almost arbitrarily.
    (Ha ha, McGuinty didn’t actually have anything to do with this, he’s a figurehead.)

    Finally, confirmation that you can’t soak the rich.

    • April 25, 2012 at 10:36

      Since taxes on the rich hit (incide?) those further down the corporate totem pole, it follows that relieving taxes on the rich will (eventually) relieve taxes further down.

      I’m not convinced that it follows. Increasing taxes on the rich hits those further down because “the rich” can (probably) demand extra salary, benefits, etc. to compensate for their increased tax burden. Reducing taxes on the rich won’t cause them to demand reduced compensation. You’d have to argue that nominal compensation for the rich would increase more slowly than the rate of inflation, reducing real compensation, or something.

      My guess is that low initial tax rates on the rich, at t=0, would produce a narrower range of compensation because firms wouldn’t have to buy highly skilled workers with the salaries of lower-skilled workers. Raising taxes on the rich mostly hits the rest of the firm, as explained above. Raising taxes, then dropping them, probably has no significant effect on salaries for the rest of the firm, because the status quo is very high salaries for the highly-skilled workers and there’s no incentive to lower them.

      I’m assuming here that “rich” == “high salary” == “high skill” == “high marginal product”.

      Maybe the Bush 43 tax cuts are a natural experiment along these lines? There’s probably too much other shit going on in the data set to really sort out tax rates as an instrumental variable.

      • April 25, 2012 at 11:13

        And I’m not convinced there’s no incentive to lower high salaries on the higher-skilled. There must be an incentive not to raise them, because otherwise they’d be rising very quickly with respect to inflation. These kinds are exactly the kinds in position to vote themselves pay raises. This is unsustainable and would kill companies that tried it. So put another way, there’s aren’t tons of companies randomly committing suicide, (I don’t think?) which means there’s some in-the-moment incentive that is preventing it.

        It is really hard to get exactly zero, so it is probably also an incentive to lower wages that are too high.

        That said, it may be very close to zero, which means it would take forever for high bonuses etc. to settle back down.

        Of course if you’re right, it means it is even more important to keep taxes on the rich low, because every time they rise – even due to accidental things like bracket creep – it causes permanent reverse trickledown.

        It really can’t be permanent though, as, worst case, eventually the firms will die of old age and be replaced by ones that are slightly more efficient by virtue of spending less on execution staff. Put it on market and R&D instead and Bob’s your uncle.

        • April 25, 2012 at 11:29

          And I’m not convinced there’s no incentive to lower high salaries on the higher-skilled. [...] These kinds are exactly the kinds in position to vote themselves pay raises.

          That second sentence is what I’m getting at. If my employer says “Hey, your taxes are going down this year, so I’m going to pay you less”, I’d start looking for a new job — especially if I’m highly skilled and in high demand. On the other hand, my employer might end up raising my nominal salary more slowly than inflation (lowering my real salary), and if my taxes are going down my real income stays the same and I’m not incented to demand more or go elsewhere.

          Another option for firms is to hire new high-skilled workers at lower salaries, but if a bunch of firms are competing for a small number of high-skilled workers this fails (someone else will hire your new guy). If a firm can sustain a salary of $BIGNUM for high-skilled workers with high taxes, and those taxes go down, it seems to me that the firm will be willing to offer up to $BIGNUM to new hires with high enough skills to demand it, even if taxes go down (and by definition we’re talking about people with high enough skills to demand lots of money).

          I guess the theory is that, if taxes go down, new hires will have less incentive to demand $BIGNUM if taxes go down, and existing high-skill workers will have less incentive to demand that their salaries stay at $BIGNUM in real (not nominal) dollars as inflation does its thing. This gets helped along by the decreasing value of the marginal dollar as real compensation goes up — high-skill workers might prefer a company that spends more on R&D.

          • April 25, 2012 at 11:39

            That second sentence is what I’m getting at. If my employer says “Hey, your taxes are going down this year, so I’m going to pay you less”, I’d start looking for a new job

            And if all other employers are doing the same thing, you don’t find a new job.
            I don’t dispute that wages are sticky. That makes them go down slowly, it doesn’t simply freeze them at whatever high they reach. Certainly it is hard to get the ball rolling, as most any single employer will get boned if they try it themselves. But, eventually, it gets worked out.
            I suspect philosophical/emotional opposition to wage cuts drives problematic layoff behaviour. It is hard to lower wages without tons of resentment. Layoffs not only cause less resentment, the resenting party is no longer the company’s problem.

            Put another way, if firms can afford $BIGNUM before taxes, they would already have been paying it before taxes, if indeed auctions for labour is the main driver of salaries. What stopped them from doing so?

            • April 25, 2012 at 11:49

              I don’t dispute that wages are sticky. That makes them go down slowly, it doesn’t simply freeze them at whatever high they reach. Certainly it is hard to get the ball rolling, as most any single employer will get boned if they try it themselves. But, eventually, it gets worked out.

              By now I think we’re just arguing about how long it’ll take for wages to “eventually” get themselves worked out.

              Put another way, if firms can afford $BIGNUM before taxes, they would already have been paying it before taxes, if indeed auctions for labour is the main driver of salaries. What stopped them from doing so?

              Imperfect information on the part of the prospective workers? I can max out my salary if I know what you’re willing to offer, what other firms are willing to offer, and what other workers like me are willing to accept. But I don’t. The same problem affects the firms, of course, but I don’t think that’s enough to drive the market towards a local maximum of $BIGNUM.

              There’s also sunk cost and inertia issues. If I can’t afford to hire you at $BIGNUM but can afford $BIGNUM-X, maybe I hire you on at the lower salary. You start working on some high-skill project and otherwise build up capital in my firm. Then your taxes go up and I need to pay you $BIGNUM to stay. If the cost of you leaving is greater than $X, I have to come up with the difference somewhere or I’m in even worse shape. (Are pro sports teams a good model of this behaviour?)


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