The Flypaper Theory of Taxation

Here’s a very interesting post by Stephen Gordon on what seems like a dull subject, namely tax incidence:

One of the more important things that distinguishes economists from non-economists is a familiarity with the notion of tax incidence. The statutory incidence of a tax (who sends the cheque to the Receiver-General?) is usually very different from its economic incidence (who is out of pocket?).

The basic intuition is simple enough. We all understand that if the government chooses to impose a tax on gasoline retailers of $0.50 per litre, customers can expect to see a similar increase in gas prices. Even if the statutory incidence falls on the sellers, the economic incidence is borne by the consumers.

The question of who ultimately bears the burden of the tax is almost entirely separate from the question of statutory incidence. (There’s even a pejorative term – the ‘flypaper theory’ – for the claim that taxes stick to those who are first touched by it.) So what does determine the economic incidence of a tax?

Gordon’s answer is that what matters is the relative elasticities of demand and supply for the the good that is being taxed. If the demand for the good is more elastic than supply over the long term, then the burden of the tax will tend to fall mostly on the sellers. If the supply for the good is more elastic than demand over the long term, then the burden of the tax will tend to fall mostly on the consumers (for a fuller explanation complete with cool graphs, read the whole post).

Gordon ends by pointing to two areas where the flypaper theory of taxation has led us seriously astray:

Corporate taxes. I’ve gone through this point several times (most recently here) and I’ve compiled a reading list on the topic over here. If you assume that we are in a small open economy where capital flows freely, the supply of capital is relatively elastic. This corresponds to the first set of graphs, and so the result is that very little of the burden of corporate taxes falls on capitalists . . . For large countries such as the US, the supply of capital is less than perfectly elastic, so the applicability of small open economy results can be problematic. But the empirical evidence for small open economies is pretty clear: the burden of corporate taxes falls mainly on workers.

Payroll taxes. These include employer contributions to EI and C/QPP as well as Worker’s Compensation premiums. But as a HRCD survey notes, long-run labour demand is more elastic than labour supply, so the ultimate effect of payroll taxes is to reduce wages: “labour’s share of the payroll tax burden in the long run is in the range of 87 to 100 percent.”

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3 Responses to The Flypaper Theory of Taxation

  1. Mike Petrik says:

    The problem of who really pays (i.e., the economic burden or incidence) the corporate income tax has been the matter of study and debate among tax scholars and economists since inception. Suffice to say we don’t know, except that it is some probably fluid combination of workers (through reduced wages), shareholders (through reduced dividends and gains), and consumers (through increased prices). But the somewhat arbitrary nature of the tax does nothing to curb its general popularity.
    This is not to say that there are not some justifications for taxing corporations. One could view the levy as a charge for the privilege of limited liability, though many economists view such limited liability as largely a legal reflection of a market driven phenomenon that would otherwise happen, albeit more clumsily, by contract. In addition, to the extent businesses consume public services they should be taxed. But these explanations cannot explain the enthusiasm for the tax among the body politic — only ignorance can.

  2. j. christian says:

    Regarding payroll taxes reducing wages: I believe David Goldhill made a similar point in his “How American Health Care Killed My Father” essay. The point being, your health care is not as cheap as you think it is.

  3. T. Shaw says:

    All taxes are borne by the consumer or the people.

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