The Economic Incidence of a Tax--part one

There is no doubt that the recently passed economic stimulus package will not stimulate the United States economy. The Obama administration is now going to turn its attention to the budget deficit. But why? If the stimulus package is good for the economy, balancing the budget must be bad. There are no economic models that specify otherwise.

Since the 1960's research on the effect of fiscal policy (government spending and taxing policy) has shown that tax cuts and increases in government spending do not stimulate the demand side of the economy. Tax cuts, however, do reduce the deadweight loss to society from taxes. Tax increases, which is what the Obama administration is going to propose to reduce the government's budget deficit, will increase the deadweight loss to society from taxes.

A deadweight loss is a loss to one group in society that is not offset by a gain elsewhere. Taxes collected are not a loss to society as a whole because they might be used to allow the government to provide a valuable good are service (such as national defense, the legal system, and possibly highways, etc.). The deadweight loss comes from the reduction in economic activity caused by the tax. If the gain from a transaction between a buyer and a seller is $5, but the government imposes a $6 tax on the transaction, it will cause the transaction to disappear.

Suppose I could work an extra hour and earn $75. My gain from working an extra hour is not $75, rather it is $75 minus the opportunity cost of my time. Suppose the cost of my time is $50. That is, if the pay for my extra hour's work is less than $50, I will not work the extra hour. If the government taxes me at a rate of 34%, and I am paid only $75 for working one more hour, then I only have $49.50 after taxes, an amount less than my $50 opportunity cost of working an extra hour.
Hence, I do not work the extra hour.

It is odd to me that many people do realize how high are marginal taxes (the taxes from working an additional hour or earning an additional dollar) in the United States. A self-employed person pays 15.3% of his earning in social security and medicare taxes (although part of this is deductible), while both employer and employee pay 7.65% of each dollar earned, for a total tax rate of 15.3%, up to earnings of $106,800. In 2009 a couple that is married, filing jointly with a taxable income of $70,000 will pay a tax of 25% on each additional dollar earned. If both husband and wife are working, they will also both have incomes below the $106,800 ceiling on social security taxes. Hence for each additional dollar they earn, they pay about 40% in federal taxes. If there is a state income tax, the tax rate for a taxable income of $70,000 is above 4% in nearly all states that have an income tax. This makes their marginal tax rate 44%. Finally, where I live state and local sales taxes total 9%. Hence for each dollar earned and spent, about 53% goes to local, state and federal governments. (The state income tax rate is actually 5% where I live, so the total tax rate is 54%.) A husband and wife who jointly have a taxable income of $70,000 are not poor, but they certainly are not rich. But if they decide to work hard to earn extra money, they will find that various governments in our dear country get a larger share of their additional earnings than they do.

Gee, is this fair?

I don't think it is, but the Obama administration does. They argue that they can increase tax rates on those earning much higher incomes, say those who earn more than $250,000 per year. But there are not that many people who earn that much. Besides, if the tax rate on an additional dollar earned becomes as high as 60 or 70%, people who are capable of earning incomes over $250,000 will figure out ways to earn their incomes in a manner that is not taxable or they might even decide not to earn it at all.

It will be interesting to see whether the current administration can tax the private sector heavily without destroying it. Finally, it will interesting to see if the administration can figure out the fact that the economic incidence of a tax is different from the statutory incidence. If my income is taxed at a rate of 55%, then I pay 55 cents in taxes for each additional dollar that I earn. But because the high tax rate causes me to reduce the number of hours that I work, I don't produce as much output as otherwise. The reduction in my output can make someone else worse off. If I were a physician and decided to take longer vacations because of my high marginal tax rate, and/or charge more for my services, it would make my patients worse off. They might be poor.
My next post will discuss this further.