Sunday, February 10, 2013

The Unfairness of Taxes

Suppose that you're a state government and the depression of 2009 severely hurts your state's economy. Prices are fluctuating, debts are rising, and unemployment is ticking upwards. What do you do? You lower the unemployment tax for businesses in the hopes that they will hire on more people since it's a little more affordable. But at the same time you borrow money from the federal government to fund unemployment insurance programs for the people who are out of work.
Fast forward 4 years so that it's the year 2013 and your deferred loan from the federal government is due. How do you continue to fund your unemployment programs with a significant amount of people still out of work?
Now, imagine that you're a state senator and you have to grapple this thorny issue. You don't necessarily want to cause people to pay higher taxes, so you brainstorm and come up with the brilliant idea that you'll be able to fund the unemployment programs by increasing the tax on businesses. Instead of making employees take home less of their paycheck, businesses will now have to foot the bill for the unemployment insurance programs. This should work, right?
Well, it works in a sense in that any tax you raise will be paid. But who you want to pay may not necessarily be paying the majority or even any of the tax you impose upon them.

Economists have a term for this and it's called the tax incidence and it describes how taxes are shared among participants in the market. Since we're talking about employers and employees, we're actually talking about a market where employees sell their skills, talents, and labor to businesses in exchange for wages and salaries. If you were to plot the different amount of people who participate in the labor market against the price of labor, you would see an overall trend where business would hire lots and lots of people if labor were very cheap. And on the other side, you would see more and more employees being available to work when the price of labor increases. This makes sense, because after all, if labor were cheap, businesses could create goods while not having to pay as much money for wages, and if labor were expensive, more people would want to to work and get paid more. But there's a happy medium that's called the equilibrium point and the market price which really just means that every worker would be hired on by businesses at the wages they both agree upon.

But getting back the to the taxes, there's also something economists call elasticity which refers to how much the quantity of a good sold changes in relation to a change in its price. Take gasoline and the price of meals at restaurants as examples. More often than not, when gasoline prices increase, we wind up paying more at the pump, usually because there aren't any other fuel options for your car. We'd call gasoline inelastic because the amount you buy isn't going to change much compared to its price. But what about an elastic good? Say a restaurant increases the price of its meals 25% so that they're $5 more expensive, but the result being that their business drops off by 50%. We'd say this is elastic, because more people are deciding to eat at home due to the higher price.
Talking about gas and meals and the amount you may buy when prices change isn't really an unfamiliar idea; it's something you probably encounter every day. But for a labor market, supply of labor and demand for labor still exhibit these same trends of elasticity.

And this idea of elasticity is actually pretty important for determining economic policy, but it also determines who has to bear the brunt of a tax.
On the whole, demand for labor is relatively elastic, and you've probably encountered this by picking up a newspaper and reading about businesses having poor profits and responding by laying off scores of employees. But the supply of employees in the marketplace is relatively inelastic, and if anything, it usually increases because more and more people enter the workforce each year. The difference between the elasticity of demand and supply means that any change in wage price will result in a large change in the amount of employees a business will want to have.
Unfortunately, an unemployment tax has the same effect as increasing wage prices in the labor market, resulting in unemployment due to decreased demand for workers. The demand actually shifts the amount of the levied tax, and will result in lower paid wages to workers.
But how is this important in determining who pays the tax? The tax affects the less elastic participants in the market, in this case the employees. Even though the businesses are paying all of the tax, they're getting most of that money from the decrease in wages and the decrease in employees that they would normally hire.

So even though businesses are the ones being taxed, you still wind up paying most of it.





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