Tax Methods Explained in One Lesson
Here is what each type of tax actually is--an attempt to simply explain the quagmire.
Imagine a worker whose job it is to produce guitars (i.e., guitars are the good). His name is Will (Will the worker). He works for the owner of the shop, Olivia (Olivia the owner). Often they are selling guitars to their best customer, Carrie (Carrie the customer).
Let’s look at how Olivia’s shop and Will’s work is impacted when Travis from the government comes by to collect taxes (Travis the taxman).1
Sales/consumption - This is a tax on market exchange (transactions) directly and indirectly on production (work) and consumption (enjoying goods and services).
When Olivia sells a guitar, Travis can impose a tax on that sale. He might do this by perhaps adding 10% to the guitar’s cost, which he then takes as the tax. Suppose a guitar costs before tax $300. At 10% sales tax it now costs $330 ($30 of which Travis takes). This much we almost all know from our experiences. However, there is more to the story.
What Travis has done is shifted the supply/demand interaction and equilibrium in this market. We don’t need to go through the graphs (but feel free to do so) to understand the dynamics. Guitars are now more expensive, which means some combination of two outcomes: customers will demand fewer of them and/or makers will supply fewer of them. Probably some of each will happen. Thus, in some combination Olivia, Will, and Carrie is worse off. Olivia has less in revenue/more in costs and/or Will’s employment isn’t quite as desired as before and/or Carrie gets fewer guitars than she wants. Travis is happy, though.
Value added - This is a tax on production (work) directly and indirectly on exchange (transactions) and consumption (enjoying goods and services).2
The same dynamics would work in a value-added tax (VAT) regime as we saw in the consumption tax above. The mechanics are just a bit different. In a VAT there is a small charge that is attached to each step in the production process. When Olivia purchases $100 in raw materials for making guitars, that transaction has a tax of suppose 10% added to it—$10 VAT. When Olivia has Will turn those raw materials into a saleable guitar that she will sell for $300, another 10% tax is applied to the value added via Will’s work at Olivia’s shop—another $20 (10% * $200). Travis will collect the entirety of the value-added tax from Olivia ($10 + $20 = $30). As with the sales tax, owner, worker, and customer are impacted the same way, negatively, sharing this burden of $30 collectively but likely unevenly.3 Travis is happy, though.
Personal income - This is a tax on production (work) directly and indirectly on consumption (enjoying goods and services) and capital (investment/savings).
At some rate and interval, Olivia pays Will for his labor. Perhaps it is by the job. Perhaps it is a fixed salary. Perhaps it is a percentage of sales or profits. Perhaps it is some combination. Regardless, Travis will tax Will some amount, say 20%, of whatever amount Olivia gives him as a tax on his personal income. If Olivia pays Will $50,000 in a year, Will has to give Travis $10,000 of it.
When Travis does this, Will has less willingness to work than he would otherwise. Because the tax takes some of the fruits of his labor, Will is less incentivized to work than he would be without the tax. This might be a big impact or a small impact.4 There are many Wills in this world facing their own unique circumstances and preferences.
Will working less isn’t the real problem or cost of the tax, though. The cost of a tax (the tax burden) is always and everywhere what is given up for it—what we have less of. This is why you cannot tax a miser. In Will’s case he will have less income after the tax meaning he has fewer claims on resources (money to buy stuff). He buys less now (lower current consumption) or he buys less in the future (saves/invests less today meaning less wealth tomorrow meaning less future consumption). Whoever was going to use Will’s income for consumption (Will or his family, etc.) is worse off. Olivia too is probably worse off from Will’s income tax alone in a knock-on effect expanded upon in the payroll tax section. Olivia is likely subject to an income tax herself along with the concomitant burdens. Travis is happy, though.
Corporate income - This is a tax on production (work) and capital (investment/savings) directly and indirectly on consumption (enjoying goods and services).
Olivia’s reward for the risk she takes in owning a business is potential profit. The accounting for this is a calculation of her business’s corporate income. When Travis taxes this income, it appears to the naive onlooker that he is taxing Olivia. That is only partially true.
What the tax does is take resources from the business. Olivia has choices about what to do with her profits. She may choose to keep these funds in the business reinvesting them to grow it—maybe she hires Will’s friend Sally to string guitars (growing the business’s work labor). Maybe she buys a machine that can double Will’s productivity (growing the business’s capital). She might also choose to distribute some or all of it to herself as a dividend. Perhaps she actually has some outside investors who own a 25% stake in the company. They too would be entitled to a share of the profits.
By taxing some of the profits, Olivia has a different choice set in front of her. Perhaps it is no longer a profitable venture to expand if 20% of the income is taken away. This is how a corporate tax is a direct tax on production and capital. But we know from the above that this isn’t the real burden of the tax. The real burden is in a reduction in consumption. That falls on some combination of groups. Carrie might not get a guitar she wants because Olivia isn’t producing as many or producing them as cheaply as she would otherwise be (expanding the business especially with adding a machine likely means Olivia can produce more for less). Will might not get a raise that he would have gotten if the firm were larger/more profitable; hence, in that case he would consume less. If Sally didn’t get hired, she obviously would consume less. Olivia and any partners in her business have less profit to share. Hence, they consume less. And this is before Travis taxes their dividends/income from the firm—an important example of double taxation.
To some degree or another these groups (customers, workers, and owners) all pay the tax by consuming less. Travis is happy, though.
Capital - This is a tax on capital (investment/savings) directly and indirectly on production (work) and consumption (enjoying goods and services).
There are many ways Travis can tax capital. If he taxes the purchase of a machine Olivia buys to make guitars, he is taxing the a capital good (the machine itself). If he taxes Olivia or her partners when they sell a part of the business to a new investor, he is taxing financial capital (equity or stock investment; aka, capital gains taxes). If he taxes the interest on a loan Olivia takes out to expand her business, he is again taxing financial capital (debt investment).
Less capital means less output. For Olivia it means her business is smaller or less profitable than it would otherwise be. The impact to her consumption from this is rather obvious. What is less obvious is that Will is affected too. If she can add a machine to the production process, Will’s productivity rises. He is worth more because the machine multiplies his labor.5 A tax on the machine is a tax on Will indirectly. One knock-on effect of this might be to price Will out of a job altogether if there is a worker at a guitar-making business outside of Travis’s jurisdiction (another country, perhaps). Olivia could just buy guitars from this supplier and herself just be a retailer. In all these ways and more the cost of the tax includes an impact to Will of a lower income and thus lower consumption himself.
As with corporate income tax, the same three groups (customers, workers, and owners) all pay the tax by consuming less. Travis is happy, though.
Payroll - This is a tax on production (work) directly and indirectly on consumption (enjoying goods and services) and capital (investment/savings).
If Travis installs a tax on Olivia based on the amount she is paying Will, he has created a payroll tax. Who pays it (Olivia or Will or some of both) is immaterial. Let me say that again. It DOES. NOT. MATTER. who writes the check to Travis. If Olivia does half and then half comes out of Will’s paycheck as is the custom in the U.S., we still have the situation that 100% of the payroll tax is a tax on employing Will. Therefore, 100% of the tax is a tax on Will’s work. Therefore, it is an added cost of employing Will. But we don’t entirely know upon whom the burden of the tax will actually fall even though we can assume it almost entirely does fall on Will. Let me explain.
A payroll tax is as stated above a tax on the employment of the employee. In this sense the employee bears the tax. But for the payroll tax, the Olivias of the world would have more resources to employ and pay Wills. So if Will is worth $25/hour to Olivia and there is a 10% payroll tax, Olivia can only pay Will $22.73/hour since that will cost her an additional $2.27/hour paid to Travis. Sooooo, Will takes home only $22.73 rather than $25 for each hour he works once a 10% payroll tax is imposed.
The impact on Will should now be obvious. He has less income just as under the income tax, which causes him to have less consumption. There is also an effect on Olivia. Because Will is less incentivized to work, he works less. This means Olivia’s business is smaller or less profitable than it would otherwise be. Thus, there is a knock-on cost effect whereby Olivia and probably Carrie are worse off. This is the subtle, hidden cost alluded to above in the income tax section. To one degree or another it exists in all of these, but it is perhaps most important to discuss here. Travis is happy, though.
Property - This is a tax on capital (investment/savings) directly and indirectly on production (work) and consumption (enjoying goods and services).
When Travis taxes the value of the land Olivia’s business sits on or the business value itself, he is deploying a particular type of capital taxation. Another way Travis could do this is by taxing Will’s home value or the value of the land it sits on. If Will lives in Arnie’s apartment house, Arnie will directly be paying this tax. However, yet again in all of these cases the technical payer of the tax is not necessarily for whom the burden of the tax falls. It likely falls on all parties to varying degrees including people far removed from the tax transaction.
We’ve already seen how a tax on capital affects owners, workers, and customers. With a property tax we can see some other ways the tax has distortive impact.
Depending on how it is calculated, the tax of Olivia’s business real estate or Will’s home real estate might make these properties more (artificially) attractive to the current owners (Olivia and Will) and less attractive to new prospective owners. This is the case when the tax is limited in how much it can increase to current owners but with catch-up provisions once a market transaction has occurred. As a result mutually beneficial trades do not happen that otherwise would.
A tax on Arnie’s apartment complex means Arnie has fewer resources to expand and offer more or better apartments with. If he is taxed on the improvements to the property, he has less incentive to make such improvements. As a result of fewer apartments or less improvements, Renée may not be move in next to Will thwarting what would otherwise be a better living opportunity for her and potential friendship for them both.
A property tax is commonly used to fund local schools and provide other public services. To this extent a property tax acts as a barrier to movement and entry for those not living in a given area. This stagnation worsens outcomes for all and directly harms those relegated to poorer areas.6 Travis is happy, though.
Inheritance/estate - This is tax on capital (investment/savings) and consumption (enjoying goods and services) indirectly.
It turns out Olivia is a very wealthy woman who happens to be a widow. When she dies, her business ownership along with her financial and personal property will be inherited by her son, Isaac. Travis has designs on this transfer of property, though.
Olivia is worth $20 million today. Travis taxes estates at a rate of 40% but excludes the first $10 million of value. Hence, Olivia’s implied estate tax burden (the tax on her transfer of her property upon her death) is $4 million ($10 million * 40%). This is a sizable sum. It is so sizable that Olivia might decide to do something about it rather than simply allow a big chunk to go to Travis.
Setting aside the complicated options of hiring expensive lawyers and financial planners to help her crave creative ways of avoiding the tax [see last footnote below], let’s focus on the resource cost of this tax burden.
One of the things Olivia can do is minimize the size of her estate by consuming it herself or growing it less—likely both. Consuming it herself means she buys goods and services she would otherwise not want. This is a resource cost to society since anything she consumes is no longer available for someone else to consume. Since she is only doing it because of the added incentive of avoiding the estate tax, she is taking it from someone who would otherwise enjoy it more than her—else she would have been consuming it in the first place.
She also can spend less effort looking for profitable opportunities. Even though she is a successful entrepreneur who has a knack for creating socially-beneficial endeavors, she now has reason to do less of this than otherwise. Founding and running businesses is difficult and risky. A significant tax on the success of which is a significant reason to avoid the whole effort.
Think about what this incentivizes at the margin. Instead of giving the government a $4 million check, she chooses to buy a $4 million yacht. She knows that the value of this yacht will decline over the coming decades before her life expectancy is over. And even if it doesn’t, it will relatively decrease in value as compared to profitable investments (like in her business) that she could otherwise make. And in the meantime, she along with Isaac and his family can enjoy the yacht. There are many ways she could fritter away the value of this estate. This is but one example.
Another thing Olivia can do is give to charity—now or at her passing. I hear the response, “What could possibly be wrong with that?” Well, it comes back to incentives as well as honoring what people actually want to do with their wealth. Olivia could give the bulk of her estate not to Isaac, but instead to a small or large collection of people in ways of her own choosing. Yet any of these will still imply an estate tax bill of $4 million. These would be the things she wants to do before the imposition of the tax. But given the tax, she may instead look for authorized charities to give $10 million away to so as to avoid the $4 million tax.
Consider that thought process. She isn’t looking for worth causes per se. She is looking for tax-avoiding causes. While these entities are authorized by the IRS to be a qualified charitable gift, they are not vetted by the IRS for worthiness. They have simply filed the proper paperwork and done what it takes to be a gift-receiving charitable organization. You don’t have to be as critical as I am of charity to suspect a problem here.
Olivia’s comparative advantage is most likely not in selecting worthy causes. Further it is not likely to be in predicting which organizations are today or will be in the future worthy of support. Beyond Olivia’s single gifts, we have a bigger problem of many, many people chasing tax deductions/avoidance via charitable giving. This is not a formula for a competitive environment generating good outcomes. The selection process becomes worse than cluttered. It becomes one where any organization can survive if not thrive no matter how poorly or destructively they operate.
Beyond all of this lies the fact that in all of these cases and especially with inheritance taxes we have the fairness issue of double, triple, nthle taxation! The wealth Olivia has earned has been hard won. She paid taxes on it many times over in many different ways (income, sales, capital gains, etc.). To ask her to pay yet again at any rate much less one of the highest rates defies justice. Travis is happy, though.
Gift - This is tax on capital (investment/savings) directly and indirectly on consumption (enjoying goods and services).
In a fashion very similar to the estate tax above, Travis may choose to tax Olivia in the event she wishes to give something above a certain value to someone else. She may want to give her son $50,000 to make a down payment on a first home. She may want to give each of five grandchildren $25,000 in investment accounts that will become theirs upon adulthood. Alternatively, Will may wish to give his lifelong friend his car that is worth $20,000 since Will can walk to work and the friend has been through some very difficult times. Travis is there for all of these gifts and more making sure to collect something.
Typically the gift tax only applies above a certain threshold, let’s say a value of $17,000. Suppose the tax is 10% of any amount over this if the gift doesn’t qualify under other guidelines like being for education. Regardless of how many loopholes and stipulations are included, the point is that giving money or valuables to others might trigger a tax to be paid by the giver—another curiosity if you think about it.
In the examples above Olivia would pay a gift tax to Travis of $3,300 ([$50,000 - $17,000] * 10%) and $800 five times over or $4,000 ([$25,000 - $17,000] * 10% * 5) and Will would pay $300 ([$20,000 - $17,000] * 10%). The obvious cost of this tax is less wealth for Olivia and Will if they give the gifts and pay the tax without any change to the gifts. One other wrinkle would be if Olivia reduces the amount of the gifts by the tax, which leaves her with more money and gives her beneficiaries less. Either way we get less consumption by one or more parties.
Another consideration of the cost of this tax is in the case of Will choosing not to gift the car. He saves the tax payment, but his friend does not get the car. This is likely a cost to Will since he wanted to give the gift and presumably to the friend who we can assume wanted to receive it. Through all of these we are left with the indirect cost of less generosity and the direct cost of less consumption. Travis is happy, though (except maybe when the car gift doesn’t occur).
Tariff - This is a tax on market exchange (transactions) directly and indirectly on production (work) and consumption (enjoying goods and services).
We’ve kind of come full circle with this one. Tariffs are a sales tax of another name.
Suppose Olivia wants to sell guitars to musicians in Canada. Canada has a version of Travis named Monte. Monte is fine with musicians in Canada purchasing Olivia’s guitars provided a tax is paid just for the fact that the guitar is coming across the border (Olivia is a U.S. citizen and her firm is a U.S. company and it is located in the U.S.). Because one of many possible qualifiers have been triggered, this guitar transaction is an import to Canada. Hence, Monte will impose the Canadian import tax on musical instruments that actually happens to be 6%.
Olivia’s guitar is priced at US$300. With a 6% tax it becomes priced at US$318 to the Canadian musician. The alternative guitar from a Canadian firm is priced at the US equivalent of US$310. Assume that in the mind of the musician Olivia’s guitar is valued at US$315 and the Canadian-made guitar is valued at only $312. (If those margins are too slim in this hypothetical, assume further that the customer is purchasing 50 guitars making the magnitude matter.)
While the customer would rather have Olivia’s guitar, the tariff has priced it out of range with its value to the customer and behind the Canadian equivalent. So instead of the Canadian musician buying the guitar he prefers from Olivia, he will settle for the lesser guitar. In this case we have a cost (incurred by the customer) without a tax being literally paid. Let’s think about another example.
Carrie is going to buy drums from a producer that happens to be in Vietnam. Now Travis is back on the scene. He is prepared to impose a tariff on this purchase of 40% (the actual tax rate assuming I’m reading this correctly). The drums were $250 before the tariff. After Travis intercedes the cost to Carrie is now $350. Carrie has $100 less to spend as she wishes. It must be pointed out that the U.S. citizen purchasing the drums, Carrie, paid the tax and incurred the burden. The Vietnamese company also will bear some of this just as in the sales tax example at the beginning of the lesson. But Carrie is clearly worse off. Tariffs are taxes paid by consumers!
Carrie has less consumption. The Canadian musician has what he believes are inferior guitars. Travis and Monte are happy, though.
Excise - This is a tax on market exchange (transactions) directly and indirectly on production (work) and consumption (enjoying goods and services).
This is a broad category that tariffs basically fall into along with the last tax covered below, Pigouvian.
Travis is not done taxing our friends. For Olivia who drives to work, he is imposing a gasoline tax of $.25 for each gallon she purchases. For Will who travels a lot, he is imposing a hotel tax of 10% on the rate of each night’s stay. For Carrie who enjoys smoking cigars while she performs, he is imposing a 25% tobacco tax on the value of each cigar purchased.
Again, these are consumption taxes of a different name and with very specific criteria. The effect is the same just focused on the specific good, service, or activity being taxed. Suppliers of the taxed thing will see their costs go up and demanders (consumers) will see some combination of the price going up and the quantity/quality available going down. These parties pay the tax and bear the burden. Travis is happy, though.
Pigouvian (e.g., carbon) - This is a tax on market exchange (transactions) directly and production (work) and consumption (enjoying goods and services) indirectly.
At times we attempt to use taxes to guide and shape policy outcomes we desire. Often these are at the behest of powerful special interests and their captured cronies in government. This asymmetrically benefits some at the expense of others with no real expectation that society at large stands to gain.
This is true as well when those with noble intentions are coopted by others into advocating for tax policy that presumably has a public policy interest but in effect fails for unintended (or intended) reasons.
However, at least theoretically there are times when the power of taxation, the power to get less of something by taxing it, becomes a tool for good. This is the case of Pigouvian taxes named for the originator of the idea, A.C. Pigou.
Suppose Travis wishes to fight climate change via reducing carbon use. He could impose a Pigouvian tax on carbon by, say, pricing each ton of carbon higher by the amount of the tax. Let’s presume this to be $50/ton. Now when Olivia buys raw materials for making guitars, each of them will have a slightly higher price so as to account for the amount of carbon attributable to it. This would include transportation among other indirect impacts similar to how a value-added tax carries forward prior tax incidence.
While this is interesting as a theoretical tool for good, it is fraught with many concerns that range from captured interest manipulating the situation to the knowledge problem of getting it right and adjusting it properly. A full examination is beyond the scope of this one lesson. But I will direct you to Lynne Kiesling to have her explain some problems and concerns.
Conclusion
Taxes effectively are punishments in the form of additional costs.7 When we tax something, we get less of what we are truly taxing. As you can see from the lesson above, in some cases the thing we are taxing is rather obvious. But at other times we are taxing in hidden ways—and usually in conjunction with an otherwise obvious tax impact.
Taxes are never a free lunch.
I resisted the temptation to name him George Taker (the greedy taxman).
Truth be told this or some version of a pure consumption tax is my third-best form of taxation. My second best is simply a per capita tax. My first best is a government so small they make enough through seigniorage and things like national park fees to pay for it all. I can dream, can’t I?
To understand the tax incidence, we would have to know the degree to which supply and demand were responsive to changes in price—elasticities. Obviously this is more than the scope of this post. Suffice it to say, if Carrie LOVES guitars, she will bear the brunt of the tax. If Carrie is so-so on guitars (price sensitive), Olivia directly and Will indirectly will bear most of the burden. Similarly if guitars are very hard to make, Olivia will be more impacted by the tax. Alternatively Carrie will if guitars are easy to make. All of these statements should be viewed in the context of all else held equal, aka, ceteris paribus.
It could also be the case that Will actually ends up working more after the tax. Before you think, “so there are benefits of taxing income in the form of more work”, understand that the fuller picture would still mean Will is worse off than before. Will’s additional work does not come for free. It comes from Will giving up something else he otherwise wanted more. Namely some form of leisure. Maybe he spends less time with his kids as he works longer at the shop or takes a second job. Remember, TANSTAAFL!
Before you Luddites declare “Ah, ha! But if the machine replaces Will, he is worse off by being out of a job”, you need to think things through beyond the first level. That outcome would indeed harm Will . . . initially. Perhaps he never recovers—never gets a job as good as what he had before. That is possible. But to be truly a net harm to Will, we need to also assume his consumption is harmed. It likely would be at least initially, but to assume permanent harm is a bridge pretty far. How so? Well, a world where capital (machines) are adding to output is a world where output (consumption) comes easier (cheaper) than otherwise. Will might have less in the scenario that he loses his job and never gets one quite as good. But is that worse than a world where there are no machines? 50% fewer such machines? Even 10% fewer of these labor substituting and labor multiplying (you always get some of both) machines? Not likely at all. Will is living in a better world (better for him alone besides all the other Wills of the world) than he could possibly imagine if he were in a world without the risk of losing his job to a machine.
I can imagine the objection here. Yes, without those property taxes the government-provided goods and services wouldn’t be that good. However, there are other ways of collecting taxes that do not have the distortive effect that property taxes do in this case. And if you’re advocating for privitization of these services (schools, waste management, fire, roads, etc.), I am all on board!
We didn’t cover the cost of complying with and avoiding/minimizing taxes. That is a cost over and above these other costs.