When a market transaction is taxed, its burden can fall on the buyer, the seller, or some combination of them. Just as in goods markets, there are buyers and sellers in the markets for factors of production. And the taxes on transactions in factor markets are income taxes.
In a recent Forbes article, John C. Goodman asks who pays the corporate income tax, and reports the findings of a team of economists that income taxes, both personal and corporate, are paid mainly by labor. In this post, we use a model economy to show how this outcome can happen.
What are the factor incomes?
The factors of production—the productive resources used to produce goods and services—are labor, capital, land, and entrepreneurship. Labor earns wages, capital earns interest, land earns a rent, and entrepreneurship earns profit.
Most personal income is from labor and most corporate income is from the other three factors of production. In the rest of the post, we focus our attention on labor and capital.
How does a personal tax on labor income work?
The division of the burden of a tax between buyers and sellers (firms and workers) depends on the price elasticities of demand and supply. The demand for labor is elastic. Because labor is ultimately limited by the size of the population, the supply of labor is inelastic. With a tax, the before-tax wage a firm pay rises and the after-tax wage a worker receives falls. Because the demand for labor is elastic and the supply of labor is inelastic, most of the tax burden falls on the sellers of labor services—the workers.
How does a corporate tax on capital income work?
The division of the burden of a corporate income tax on capital income depends on the price elasticities of the demand for and supply of capital. The demand for capital is elastic. Because saving and foreign borrowing can be used to obtain capital, the supply of capital is elastic. When capital income is taxed, the equilibrium interest rate rises by the full amount of the tax. But firms are only willing to use the quantity of capital at which the value of marginal product of capital equals its interest rate. The quantity of capital used decreases.
Why does labor lose from a corporate income tax?
When firms use a smaller quantity of capital, labor becomes less productive, and the demand for labor decreases. If the supply of labor is inelastic, the equilibrium wage rate falls and quantity of labor employed changes minimally. If the supply of labor is perfectly inelastic, the equilibrium wage rate falls sharply but the quantity of labor employed doesn’t change.
Let’s look at two markets for factors of production.
Multiple Choice Test: Personal and Corporate Income Taxes