L.A. Liberty

Taxing Consumption

The first law of incidence can be laid down immediately, and it is a rather radical one: No tax can be shifted forward. In other words, no tax can be shifted from seller to buyer and on to the ultimate consumer. … It is generally considered that any tax on production or sales increases the cost of production and therefore is passed on as an increase in price to the consumer. Prices, however, are never determined by costs of production, but rather the reverse is true. The price of a good is determined by its total stock in existence and the demand schedule for it on the market. But the demand schedule is not affected at all by the tax. The selling price is set by any firm at the maximum net revenue point, and any higher price, given the demand schedule, will simply decrease net revenue. A tax, therefore, cannot be passed on to the consumer.

It is true that a tax can be shifted forward, in a sense, if the tax causes the supply of the good to decrease, and therefore the price to rise on the market. This can hardly be called shifting per se, however, for shifting implies that the tax is passed on with little or no trouble to the producer. If some producers must go out of business in order for the tax to be “shifted,” it is hardly shifting in the proper sense but should be placed in the category of other effects of taxation.

A general sales tax is the classic example of a tax on producers that is believed to be shifted forward. The government, let us say, imposes a 20-percent tax on all sales at retail. We shall assume that the tax can be equally well enforced in all branches of sales. To most people, it seems obvious that the business will simply add 20 percent to their selling prices and merely serve as unpaid collection agencies for the government. The problem is hardly that simple, however. In fact, as we have seen, there is no reason whatever to believe that prices can be raised at all. Prices are already at the point of maximum net revenue, the stock has not been decreased, and demand schedules have not changed. Therefore, prices cannot be increased. Furthermore, if we look at the general array of prices, these are determined by the supply of and the demand for money. For the array of prices to rise, there must be an increase in the supply of money, a decrease in the schedule of the demand for money, or both. Yet neither of these alternatives has occurred. The demand for money to hold has not decreased, the supply of goods available for money has not declined, and the supply of money has remained constant. There is no possible way that a general price increase can be obtained.

It should be quite evident that if businesses were able to pass tax increases along to the consumer in the form of higher prices, they would have raised these prices already without waiting for the spur of a tax increase. Businesses do not deliberately peg along at the lowest selling prices they can find. If the state of demand had permitted higher prices, firms would have taken advantage of this fact long before. It might be objected that a sales tax increase is general and therefore that all the firms together can shift the tax. Each firm, however, follows the state of the demand curve for its ownproduct, and none of these demand curves has changed. A tax increase does nothing to make higher prices more profitable.

The myth that a sales tax can be shifted forward is comparable to the myth that a general union-imposed wage increase can be shifted forward to higher prices, thereby “causing inflation.” There is no way that the general array of prices can rise, and the only result of such a wage increase will be mass unemployment.

Many people are misled by the fact that the price the consumer pays must necessarily include the tax. When someone goes to a movie and sees prominently posted the information that the $1.00 admission covers a “price” of 85 cents and a tax of 15 cents, he tends to conclude that the tax has simply been added on to the “price.” But $1.00 is the price, not 85 cents, the latter sum being the income accruing to the firm after taxes. This income might well have been reduced to allow for payment of taxes.

In fact, this is precisely the effect of a general sales tax. Its immediate impact lowers the gross revenue of firms by the amount of the tax. In the long run, of course, firms cannot pay the tax, for their loss in gross revenue is imputed back to interest income by capitalists and to wages and rents earned by original factors—labor and ground land. A decrease in the gross revenue of retail firms is reflected back to a decreased demand for the products of all the higher-order firms. All the firms, however, earn, in the long run, a pure uniform interest return. …

We thus see this important truth: A consumption tax is always shifted so as to become an income tax, though at a lower rate. In fact, the 20-percent consumption tax becomes equivalent to a 15-percent income tax. This is a very important argument against the plan. Fisher’s attempt to tax consumption alone must fail; the tax is shifted by the individual until it becomes an income tax, albeit at a lower rate than the equivalent income tax.

Thus, the rather startling conclusion is reached in our analysis that there can be no tax on consumption alone; all consumption taxes resolve themselves in one way or another into taxes on incomes. Of course, as is true of the direct consumption tax, the effect of the rate is discounted. And here perhaps lies a clue to the relative predilection that free-market economists have shown toward consumption taxes. Their charm, in the final analysis, consists in the discounting—in the fact that the same rate in a consumption tax has the effect of a lower rate of income tax. The tax burden on society and the market is lower. This reduction of the tax burden may be a very commendable objective, but it should be stated as such, and it should be realized that the problem lies not so much in the type of tax levied as in the over-all burden of taxes on individuals in the society.

- Murray Rothbard, Power & Market