Taxes passed on to consumers

Economics Economics Questions
1

One often hears that taxes passed on businesses will be passed onto consumers. Some dispute this claim. By looking at this in a methodologically individualist fashion, doesn’t the answer become clear?

If taxes are raised, say the corporate tax is raised from 25 to 30%, each business would want to make up for the losses by raising their own prices. But how can they? If they raise their price and no one else does, then they start losing out on a share of the market. No business wants to be the first one to raise their prices and scare off customers.

However, if one is able to raise one’s prices in response to a tax increase with the cooperation of the rest of the industry, then the tax is indeed passed onto consumers. The standard Libertarian line on cartelization is that industries can cartelize if they use the state to decrease the amount of present and possible future producers within a given industry. If there is just a handful of businesses in a given industry they can come to agreements with each other and can manage to pass the tax onto consumers by acting in concert.

Rothbard pointed out that a raise in taxes on business will tend to reduce the amount of producers within a given industry simply because the increased costs of business will drive some producers out. So in a roundabout (non-BohmBawerkian) sense, increased taxes can manifest themselves as taxes on consumers insofar as they are able to catalyze a cartelization of an industry.

So in conclusion: saying that taxes on businesses are taxes on consumers is an oversimplification. In a purely free market, that would be false. In a market of cartelists, it is not necessarily false. And the action of increasing taxation is to the eventual advantage of cartelists.

2

You assume that they pass them on by raising prices. They can do other things that aren’t as visible in the short-term: lower quality of product/support, reduce volume of product (The Consumerist covers this often).

3

What is the difference between reducing the volume of product and increasing the price as expressed in prices?

4

Jargon,

…industries can cartelize if they use the state to decrease the amount of present and possible future producers within a given industry.

I thought the laws had to impose price controls as well.

EDIT: The logic being that without price controls the members of the cartel will, despite the agreements, still try to get a larger market share by lowering their prices to what supply and demand dictates.

5

Why? Can’t they impose price controls or supply quotas privately?

6

Sorry for not elaborating.

I edited previous post to explain.

In short, what’s to stop one fellow from backing out of the agreement and lowering prices in order to make more money?

7

Raising the price is visible in the short-term, and on the shelf, makes the competition look like a better deal, which I took as your argument as to why they can’t directly pass the costs on. Lowering quality is very hard to see on the shelf, or even when you get the product in your hands unless it’s blatant major reduction.

8

Consumption taxes in particular are really a haphazard income tax, imputed back to factors of production (wages and returns on capital).

9

In the UK they have the sales tax or VAT, where businesses are exempt from paying sales tax on purchases but have to pay sales tax on sales of their goods and services to the government. This type of tax gets passed on to consumers pretty much directly. If the sales tax is increased the price for goods and services increases almost instantly.

10

“If taxes are raised, say the corporate tax is raised from 25 to 30%, each business would want to make up for the losses by raising their own prices. But how can they? If they raise their price and no one else does, then they start losing out on a share of the market. No business wants to be the first one to raise their prices and scare off customers.”

Well, let’s be clear about what kind of tax we’re talking about. If you’re talking about a corporate income tax, then that is essentially a tax on profit. In that case, I’d agree that such a tax would not raise prices in the short run. The reason being that companies would still want make the biggest profit possible just as they would before the tax was imposed, it’s just that they would get to enjoy a smaller fraction of those profits as a result of the tax (or more technically, a corporate tax doesn’t change the marginal decision making of the firm in the short-run).

But what if we are talking about a per-unit tax, like a cigarette tax? In that case, then i think prices would typically increase. I think the essential thing is that even if firms can’t change prices (and I agree that firms operating in competitive markets will have less leeway for doing this), they can still change how much they produce and this will indirectly result in a price change.

Think about it this way.

Suppose that before a cigarette tax is imposed, cigarettes sell for $3 per pack and there are 10 cigarette companies each selling 1,000 packs of smokes per day. Now suppose a $2 per pack tax is imposed on cigarette producers. If the firms do not raise their prices, this means they may charge $3 per pack, but they actually only earn $1 per pack they sell. This will likely lead all firms to want cut back production (they are earning less on each pack, but their costs of production have not changed). For example, say the firms want to cut back from 1,000 packs per day to 500 packs.

But this is going to cause problems. Since the price is $3 per pack, consumers will want to buy 10,000 packs. However, the 10 cigarette companies combined are only willing to sell 5,000 packs at that price. As a result, we have a shortage of cigarettes (quantity demanded exceeds quantity supplied). So there is no guarantee that when you go to the store you will find a pack of cigarettes waiting for you.

Of course, the market process doesn’t stop here. There will be some consumers that are willing to pay more than $3 per pack for cigarettes. So they may offer the cigarette producer more money to ensure that they can buy with cigarettes with certainty. These sorts of offers will bid up the price of cigarettes. As a result, some portion of the tax will passed along to consumers in the form of higher prices. In some extreme cases, all of the tax burden will be passed on to consumers (if demand is perfectly inelastic or supply is perfectly elastic). But that isn’t all that important for the economic logic of what’s going on.

11

  1. …a corporate tax doesn’t change the marginal decision making of the firm in the short-run…

  2. …they may charge $3 per pack, but they actually only earn $1 per pack…This will likely lead all firms to want cut back production (they are earning less on each pack, but their costs of production have not changed).

Why does the logic of 2 not apply in case 1?

12

I always thought that the problem with free-market cartelization wasn’t that pool-members would back out, but that the pool would be challenged by an outsider after a period of intolerably high prices.

13

Ok that makes sense: taxes on income, after all is said and done, will have to be humped by producers, given the scenario that they aren’t able to form and hold a cartelistic agreement. Taxes on the product, before anything is done, will induce them to restrict supply because their costs of production have gone up. He likely wouldn’t choose to reduce production under an increasing income tax because he would still be taxed on the increased profits from cutting costs.

14

http://media.mises.org/mp3/Rothspeak/Cartels.mp3

That’s where I got it from.

15

I don’t usually feel like i know enough to chime in, but this time I think I recognize something! Arent u missing the whole “price sensitivity” thing? Didn’t Rothbard say:

“Prices, at all times, tend to be set at the maximum net revenue point for each seller. If the sellers can simply pass the 20 percent increase in costs onto the consumers, why did they have to wait until a sales tax to raise prices? Prices are already at highest net income levels for each firm. Any increase in cost, therefore, will have to be absorbed by the firm; it cannot be passed forward to the consumers.”

(I can’t take credit for this, I remembered it from John James Greatest Hits, which made ti easy to find again.)

16

It seems to me that would only be valid for a market with one seller. With multiple sellers, part of the cap on prices is the potential for lost market share when another seller offers the product for less. Increasing the price by 20 percent might maximize revenue, but only if everyone increases their prices - which you may see with a tax increase.

17

See Rotbhard’s explanation of this phenomenon in Power & Market the section on Binary Intervention (Chapter 4, I believe).

18

By this logic, a 90% tax wouldn’t result in anything passed on to consumers. I think the argument is flawed because the stability before was in a different set of circumstances; the new tax changes the context and therefore the prices. It’s like any other increase in source materials cost.

19

But why should a price change not affect buying decisions? doesnt the thing we’re talking about have to be ‘inelastic’ or something? How many products have a demand that is inelastic?

don’t those kind of increases affect the bottom line? Isn’t that the whole reason businesses try to ‘cut costs’, so they can increasetheir profit? If costs go up, the biz may try to raise its prices, but i don’t see why we should expect the same quantiy sold.

20

Why does the logic of 2 not apply in case 1?

Smiling Dave,

Because you have to keep in mind that these are two different kinds of taxes. The first tax is a tax on profits. Such a tax does not alter which level of production is most profitable. It only affects how much of the profits you earn you get to keep after you pay your tax bill.

Think about it this way. Let’s say that a cigarette manufacturer decides that producing 1,000 packs per day is the production level that will maximize his profits (say he earns $1 million in profit). His profits are their MAXIMUM at 1,000 packs. This means that if he reduces production he will lower his profits. For example, say if he reduces production to 900 packs he only earn $0.9 million. Likewise, if he increases production he will lower profits. For example, say if he increases production to 1,100 packs he will only earn $0.9 million in profits.

If this was not the case he would no be maximizing profits.

Now, let’s say a 25% corporate income tax is imposed. What will the firm do? If keeps producing 1,000 packs he will now only earn $0.75 million in profits ($1*(1-0.25)=0.75). Similarly, if he either cuts production by 100 units or increases production by 100 units he will only earn $0.675 million in profits ($0.9(1-0.25)=$0.675). In other words, he will just earn even lower profits than if he didn’t change production at all.

This should make sense. It still costs the company the same ammount as before to produce cigarettes as before. And the demand schedule for cigaretted has not changed. So why would the profit maximizing production level?

This is not the case with a per-pack tax on cigarettes. As Jargon notes, such a tax essentially makes cigarettes more expensive to produce. So the consequences of such a tax should be the same as if the cost of an input of production increases.