Legal vs Economic Incidence: Estimating Who Pays Taxes – Mike Klemens
Legal vs Economic Incidence: Estimating Who Pays Taxes
March 2021 (74.2)
by Mike Klemens*
Illinois Governor J.B. Pritzker has said that, in these pandemic driven times, hardworking Illinois families should not have to pay more taxes. His 2022 budget has instead proposed to raise taxes only on the business community, by closing “unaffordable corporate loopholes”. But he can’t do both. The notion that raising taxes on businesses protects families ignores a critical fact: individuals ultimately pay a significant amount of taxes originally imposed on businesses. As summarized in the Texas Comptroller of Public Accounts latest Tax Exemptions & Tax Incidence Report, “Any tax levied directly on a business will ultimately be paid by real, live people – if not consumers via higher prices, then business owners via reduced profits or employees via reduced wages.”
The Texas Comptroller highlights the difference between legal incidence (who writes the check to the government) and economic incidence (who ultimately bears the cost of a particular tax). In some situations, it’s easy to identify who pays, because a tax’s legal and economic incidence are the same. The wage earner pays personal income tax on his/her earnings, and the purchaser pays the sales tax on a new pair of jeans. Other situations are more complex. The excise tax on cigarettes is widely assumed to be paid by the smoker even though it’s remitted by the distributor. Infinitely more complex is the taxation of a multi-state corporation that produces goods in Illinois, sells them in 20 states and has shareholders in all 50 states. Who really pays the Illinois income tax imposed on the corporation’s profits?
Take a simple example of a new tax of $1 on every pizza sold. Joe’s Pizza Parlor will have the legal incidence of this tax; he must pay it to the government. If Joe raises the price of each pizza sold by $1, his customers will see the economic incidence. If Joe tells his workers he can’t raise the price $1 so he needs to cut their wages, his employees will bear the economic incidence of the tax. Or, if Joe decides to do neither and just make less money, he would bear both the legal and economic incidence of the tax.
While studies that measure the amount of taxes paid by various income groups are common, those that attempt to distinguish between legal incidence and economic incidence are rare. The Institute for Taxation and Economic Analysis (ITEP) recognizes the shift of tax burden from one party to another in its publication, Who Pays? A Distributional Analysis of Tax Systems in All 50 States. For example, ITEP attributes a quarter of economic incidence of corporate income tax to labor.
We could find only two states, Texas and Minnesota, that conduct incidence studies. The Texas report referenced above looks at the Franchise Tax (a modified income tax), the largest Texas business tax at $4.3 billion, and determines that the economic incidence of the tax on Texas residents (customers, employees, and owners) is $2.7 billion, with the remaining $1.6 billion exported to out of state taxpayers.
Minnesota statutes require a biennial tax incidence report. The 2021 report is an impressive 164-page effort, replete with charts, tables, and an explanation of all the assumptions made. The report is done by the Minnesota Department of Revenue, which has access to Minnesota state and federal tax returns, state property tax refund returns, information from other Minnesota state agencies, U.S. Census Bureau data, and the Consumer Expenditure Survey conducted by the U.S. Department of Labor. They start with a 137,399 stratified random sample of Minnesota households and project results to all Minnesota households. Its stated objective is to provide information to taxpayers and policymakers on the equity of the overall distribution of Minnesota taxes.
The Minnesota study sets out a three-step process for determining the economic incidence of taxes on Minnesota households:
- Step 1 – initial imposition of tax – the legal incidence.
- Step 2 – estimating the shift of tax to Minnesota consumers, capital, labor, and land and exported to non-residents.
- Step 3 – Allocation of the shifted tax burden among Minnesota households broken into 10 deciles. The lowest decile is households with income of $14,694 and below and highest is households with incomes of $181,553 or greater.
The product of the Minnesota study is an effective tax rate for each decile of income – taxes directly or indirectly paid by households in each decile divided by household income for that decile. When all state and local taxes are considered, the effective rates are relatively the same, except for the lowest household income decile. The study attributes that to Minnesota’s progressive income tax structure, refundable income tax credits, and credits given homeowners and renters for property taxes paid. The authors also point out that results for the lowest decile may be affected by households claiming business losses and by underreported income for food stamps and housing subsidies, suggesting that the lowest decile’s effective tax rates were overstated by an “unknown but possibly significant amount.”
Looking more closely, the report found that both the corporate franchise tax and the general sales and use tax were regressive (i.e. the effective rate decreased as income increased), across all deciles. That was not true of the commercial property tax which was regressive through the first five deciles, leveled off, and was progressive (effective tax rate increased as income increased) for the highest income deciles. While it is interesting to ponder how commercial property taxes are the least regressive of these three taxes, we are going to limit our attention to the study’s attempt to measure the shift of tax initially imposed on businesses onto households.
For a more in-depth evaluation of economic incidence in Illinois and Minnesota see “Looking More Closely: Who Really Pays Illinois Taxes?”, Tax Facts, March/April 2016 or check the Minnesota Tax Incidence Study – 2021 Tax Incidence Studies.
Let’s take a huge leap and assume that Illinois is Minnesota and apply the calculations done for Step 2 of the Minnesota study to Illinois. We know that’s not ideal, but we also note that it is the best available measure of the shift of taxes initially imposed on business onto individuals—the real tax burden. We apply the Minnesota numbers to Illinois for major tax types in turn, below:
Illinois Corporate Income Tax
The $3.1 billion projected in the 2022 Budget for corporate income tax would (if Illinois follows the results in Minnesota) have been borne as follows:
- $1.3 billion by Illinois consumers in terms of higher prices
- $137 million by Illinois workers in reduced wages
- $291 million by Illinois business owners in reduced profits.
- Another $1.3 billion would have been exported to business owners and consumers outside of Illinois.
Illinois State Sales Tax
The $10.7 billion projected in the 2022 budget for state sales and use tax would have been borne as follows:
- $4.8 billion paid directly by Illinois consumers.
- $3.0 billion by Illinois consumers in terms of higher prices.
- $83 million by Illinois workers in reduced wages.
- $413 million by Illinois business owners in reduced profits.
- Another $2.5 billion would have been exported to business owners and consumers outside of Illinois.
Local Property Taxes on Commercial Property
The $8.5 billion billed in property taxes on commercial property paid in 2020 would have been borne as follows:
- $2.7 billion by Illinois consumers in higher prices.
- $183 million by Illinois workers in reduced wages.
- $1.6 billion by Illinois business owners in reduced profits.
- Another $3.9 billion would have been exported to business owners and consumers outside of Illinois.
Applying the Minnesota results to Illinois means that, in each of the three major Illinois business taxes, Illinois consumers bear more of the burden than do owners of the businesses.
Economic theory, and common sense, tells us that costs of doing business (including taxes) will be borne by consumers, workers, and business owners. The Minnesota Tax Incidence Study’s effort to quantify that impact validates that belief and reminds citizens and policy makers that a significant portion of business taxes are borne by citizens.
In these times where the phrase “pay their fair share” pops up repeatedly in talk of taxation, there are two lessons:
1) Suggesting that a tax can impact businesses instead of citizens, ignores the fact that most business taxes are passed on to citizens.
2) On the flip side, businesses that complain their taxes are too high similarly ignore the fact that their customers and employees end up paying most of those taxes.
As we have said repeatedly – Taxes are complicated.
*Mike Klemens does tax policy research for the Taxpayers’ Federation of Illinois.