If you have received a paycheck you probably noticed that taxes were deducted from the amount you earned. One of these taxes is called FICA, an acronym for the Federal Insurance Contribution act. The federal government uses the revenue from the FICA tax to pay for social security and Medicare the income support and health care programs for the elderly. FICA is an example of a payroll tax, which in a tax on the wages those firms pay their workers. In 2005, the total FICA tax for the typical worker was 15.3 per cent of earnings.
Who do you think bears the burden of this payroll tax – firms or workers? When congress passed this legislation it tried to mandate a division of the tax burden. According to the law, half of the tax is paid by firms, and half is paid by workers. That is, half of the tax is paid out of firms’ revenue and half is deducted from workers paychecks. The amount that shows up as a deduction of your pay stub is the worker contribution,
Our analysis of tax incidence however, shows that lawmakers cannot so easily dictate the distribution of a tax burden. To illustrate we can analyze a payroll tax as merely a tax on a good where the good is labor and the price is the wage. The key feature of the payroll tax is that it places a wedge between the wage that firms pay and the wage that workers receive. When a payroll tax is enacted the wage received by workers falls and the wages paid by firms rises. In the end, workers and firms share the burden of the tax, much as the legislation requires. Yet this division of the tax burden between workers and firms has nothing to do with the legislated division. The division of the burden is not necessarily fifty – fifty and the same outcome would prevail if the law levied the entire tax on workers or if it levied the entire tax on firms.
This example shows that the most basic lesson of tax incidents is often overlooked in public debate. Lawmakers can decide whether a tax comes from the buyer’s pocket or from the seller’s but they cannot legislate the true burden of a tax. Rather, tax incidence depends o the forces of supply and demand.
Elasticity and Tax Incidence:
When a good is taxed buyers and sellers of the good, share the burden of the tax. But how exactly is the tax burden divided? Only rarely will it be shared equally. To see how the burden is divided, consider the impact of taxation in the two markets. In both cases, the figure shows the initial demand curve, the initial supply curve, and a tax that drives a wedge between the mount paid by buyers and the amount received by sellers. (Not drawn in either panel of the figure is the new supply or demand curve. Which curve shifts depends on whether the tax is levied on buyers or sellers. As we have seen, this is irrelevant for the incidence of the tax). The difference in the two panels is the relative elasticity of supply and demand.
A tax in a market with very elastic supply and relatively inelastic demand. That is, sellers are very responsive to changes in the price of the good (so the supply curve is relatively flat), whereas buyers are not very responsive (so the demand curve is relatively steep). When a tax is imposed on a market with these elasticities the price received by sellers does not fall much, so sellers bear only a small burden, By contrast the price paid by buyers’ rises substantially indicating that buyers bear most of the burden of the tax.
A tax in a market with relatively inelastic supply and very elastic demand. In this case sellers are not very responsive to changes in the price (so the supply curve is steeper) whereas buyers are very responsive (so the demand curve is flatter). When a tax is imposed the price paid by buyers does not rise much but the price received by sellers falls substantially. Thus, sellers bear most of the burden of the tax.
A general lesson about how the burden of a tax is divided. A tax burden falls more heavily on the side of the market that is less elastic. Why is this true? In essence the elasticity measures the willingness of buyers or sellers to leave the market when conditions become unfavorable. A small elasticity of demand means that buyers do not have good alternatives to consuming this particular god. A small elasticity of supply means that sellers do not have good alternatives to producing this particular go, When the good is taxed, the side of the market with fewer good alternatives cannot easily leave the market and must therefore bear move of the burden of the tax.
Most labor economists believe that the supply of labor is much less elastic than the demand. This means that workers rather than firms bar most of the burden of the payroll tax. In other words, the distribution of the tax burden is not at all close to the fifty-fifty split that lawmakers intended.