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Article Excerpt
Abstract--This paper argues that who remits tax may be an important aspect of implementing a tax system, in spite of standard economic analysis that maintains that which side of a taxed market remits is completely irrelevant. The irrelevance proposition does not apply in the presence of avoidance and evasion (i.e., in all real tax systems) because the total resource costs of administering a given effective tax structure may vary depending on the remittance system and because the opportunities for avoidance and evasion and the technology of enforcement affect the incentive to demand and supply the taxed activity.
ISSUES AND MOTIVATION
Nearly all of the modern economic theory of taxation is concerned with what actions or states of affairs trigger tax liability, and virtually none is concerned with who or what entity remits funds to the government to cover that liability. Indeed, both elementary public finance textbooks and advanced surveys suggest that the remittance responsibility--such as whether the buyer or seller of a commodity must remit any sales tax triggered by the sale--is irrelevant to the consequences of a tax.
Some would find the dismissal of remittance to be surprising. For example, many conservatives consider the introduction of income tax withholding in 1943 to be a crucial characteristic of the U.S. income tax. Dick Armey, the former Republican House Majority leader, has called it "the crucial deceptive device that has made big government possible" and Milton Friedman, who helped develop it when he was at the Treasury Department during World War II, later considered it a mistake and called for its abolition. (1) To tax administrators and tax practitioners, particularly those who work in developing countries, the remittance system is not irrelevant, and may instead be critical to the efficient and equitable operation a tax system. Certain aspects of remittance systems are pervasive. We observe, for example, that remittance by business rather than by individuals pervades modern tax systems. Among business--based remittance systems, the value added tax has, largely on implementation grounds, come to dominate the retail sales tax for broad--based, non--graduated, consumption taxes. Despite their prominence in tax policy considerations, these implementation issues have received very little careful analytical attention.
In this paper I contribute to such a consideration by addressing some questions in the economics of tax remittance. I discuss the conditions under which the standard presumption of irrelevance holds, and conditions under which it breaks down. I then relate this theory to two issues. The first is income tax withholding, where I note the overwhelming importance of firms in tax remittance and argue that to understand the impact of taxes one needs to explicitly introduce firms into the positive and normative theory of taxation. Second, I consider remittance in the context of the choice between a value added tax (henceforth VAT) and a retail sales tax (RST). This paper is not intended as a comprehensive review of remittance issues that arise in taxation. (2)
Before proceeding, some limits on this inquiry should be noted. Although remittance is an important aspect of a tax system, it is not the only important aspect of how a tax system is implemented. Also important are the administration and enforcement of the tax rules, as well as the design of the tax rules with the administrative and enforcement issues in mind. One key element is the extent of information reporting--reports to the tax authority from one party about transactions that have tax consequences for another party.
For example, employers provide information reports regarding payments of wages and salaries to employees, presumably so that the tax authority can check that the employee reported the wages and salaries on their personal tax return and also to facilitate a reconciliation with the individual taxpayer's claims about the amount withheld on his behalf. With final (and perhaps exact) withholding, the information report is not as critical, because no reconciliation with the other party (employee, in this example) is required. (3)
The economics of remittance is distinct from the framing effects of tax policy--whether the form (holding substance constant) in which a policy is presented affects its consequences, because it affects how people react to it. For the most part, I will put framing issues aside, although I address briefly the issue of the role of remittance in the perception of tax policy.
TERMINOLOGY
Because one of the objectives of this paper is to clarify the distinction between what triggers tax liability and how these rules are implemented, I will try to be very careful about the usage of some key terms. This may be a bit disconcerting because the common, and sometimes official, terminology used to describe a tax system might not match up with the consistent terminology I employ, and recommend.
The key to the quest for semantic clarity is the careful use of the term "remit" and its various forms. I will here use (and urge the use of elsewhere) "remit" tax to refer to some person or entity in the private sector writing a check or otherwise transmitting funds to the tax authority. (4) For example, under a value added tax all businesses (perhaps above a prescribed turnover threshold) may be required to remit funds to the tax authority, while under a pure retail sales tax only retail businesses are required to remit money. It may be that, under certain conditions, a broad--based uniform VAT and RST end up having the same consequences, but even so the remittance pattern is quite different. Indeed, my principal point is that in many situations the remittance rules, and more generally the implementation, of a tax system matter for its consequences.
A compact lexicon based on the concept of remittance defines a tax system as a set of rules, regulations, and procedures that define 1) what events and/or states of the world trigger tax liability and how to calculate the liability (tax bases and rates), 2) who or what entity must remit that tax and when (remittance rules), and 3) the procedures for monitoring and ensuring compliance, including the information reporting requirements and the consequences (e.g., penalties) of not remitting the liability in a timely fashion (administrative and enforcement rules). Under the assumption that what triggers tax liability can be ascertained and collected costlessly, 2) is irrelevant and 3) is unnecessary. These elements of a tax system together determine the incidence of a tax system--who bears the burden--the allocation effects, and the total costs of collecting the tax revenue, including the distortion, the administrative, and compliance costs.
It is crucially important to distinguish between 1) the person who ultimately bears the burden of a tax and 2) who remits tax. This is because a tax system generally causes changes in pre--tax prices, and thereby the burden may be shifted away from the apparent statutory bearer. For example, a tax triggered by labor earnings will in general increase the pre--tax wage, so that the after--tax wage falls by less than the tax. Thus, the burden of the tax is shared between employers, who face a higher pre--tax wage (cost of labor) than otherwise, and employees who receive a lower after--tax wage rate than in the absence of the tax. Exactly how this burden is shared (i.e., how much the pre--tax wage rate increases and how much the after--tax wage declines) depends largely on the relative elasticity of the demand for labor and supply of labor: (5) more inelastic labor supply and more elastic labor demand makes it more likely that employees will bear the burden of the tax; more inelastic labor demand and more elastic labor supply make it more likely that employers will bear the burden of the tax. (6) I will say that an individual "bears the burden" of a tax to the extent that he or she experiences a loss of utility (sometimes referred to as "real income") because of the tax. (7)
The compact lexicon I propose avoids the use of several terms that are commonly used to describe tax systems. One such term is the statutory incidence, with a loose shorthand of who the tax is levied "on." I will certainly talk about withholding, which refers to a situation in which the remitter differs from the statutory bearer. But, framing issues aside, what anyone calls a tax, or who the law says the tax is "on," is irrelevant to its impact except insofar as this affects who has the legal responsibility to remit and the consequences of failure to remit. For example, under the U.S. personal income tax, the amount of tax remitted by the employer/ withholder does not generally equal the actual liability, and it is the responsibility of the individual to either remit the difference (if positive), or to file for a refund. The code also specifies how much the employer must remit on the employees' behalf, and specifies penalties for failure to remit appropriately. In common parlance, we say that the personal income tax is a tax on the individual, even though much of it must be remitted by the individual's employer and, as discussed below, the ultimate incidence may be shifted from the employee--individual as well as from the employer--remitter.
Because of the imprecision of its meaning, I will avoid saying that an individual (or a legal entity) "pays" taxes. Writers on taxation, including economists, use the phrase to "pay" taxes sometimes to refer to the remittance of money to the tax authority, and sometimes to refer to bearing the burden of a tax. In some situations the meaning of each usage is clear, but in others it is not. The distinction is especially important when we move beyond the standard economics theory of tax triggering to incorporate a theory of tax remittance. Rather than having to specify which meaning of "pay" applies in a given context, I will avoid it altogether.
Finally, I will not say that businesses "collect" taxes. (8) (I will, though, use the word "collect" in the sense that the tax authority collects tax from those in the private sector who remit taxes.) Businesses often remit tax, but it can be confusing to assert, for example, that a business collects--but does not remit--a given amount of tax. It is certainly true that the owners of a non--remitting business may benefit (the opposite of "bear a burden") from the existence of a tax, for example, if the business's competitors mostly do remit and thereby cause the price of the product to rise. In some cases, a business may charge a different gross price to "taxable" consumers than it does to nontaxable consumers, and remit no tax. In that case there are additional distributional implications to be considered, but it is still true that the tax authority receives nothing, and "collect" can only refer to how the remittance of tax by other firms or the implied claim of remittance by the company in question affects the gross--of--tax price the firm receives. This, however, is an issue of burden, rather than remittance. (9)
In some situations the remittance is due to the tax authority at some time after the transaction (or state of the world) that triggers the tax liability; in this case the effective tax rate is lower than the stated tax rate because of the time value of money, sometimes referred to as the "cash--flow" value of the delayed remittance. (10) The incidence and other consequences of this way of delivering a tax reduction are not fundamentally different from an explicit tax cut.
WHEN REMITTANCE DOESN'T MATTER
In the standard theory of optimal taxation, all the information needed to assess tax liability is observed costlessly by everyone. This assumption about the availability of information precludes tax evasion and, thus, the necessity of an enforcement regime. It also implies the standard textbook canon: which side of a market remits (or is apparently liable for) a tax is irrelevant, both for the ultimate incidence (i.e., who bears the burden) of the levy as well as its efficiency and allocation consequences. (11) Dalton (1954) called the former the "Theorem of the Invariance of Tax Incidence." (12)
This invariance, or irrelevance, proposition occupies a central position in the economics of taxation. Consider its treatment in Rosen (2002), a leading American undergraduate public finance textbook. Rosen first defines the "statutory incidence" of a tax as who is "legally responsible for the tax," and the "economic incidence" as the "change in the distribution of private real income induced by a tax." The irrelevance proposition is then stated as follows: "knowledge of statutory incidence tells us essentially nothing about who really pays the tax" (p. 254); here the emphasis is in the original, and the term "pays" obviously refers to the change in utility, or real private income and "statutory incidence" refers to remittance responsibility, although the word remittance is not mentioned. Rosen later presents a compelling remittance metaphor: "It is irrelevant whether the tax collector (figuratively) stands next to consumers and takes u dollars every time they pay for a gallon of champagne or stands next to sellers and collects u dollars from them whenever they sell a gallon" (p. 261). Undergraduate public finance students (and instructors) are familiar with the diagrammatic version of the irrelevance proposition: the imposition of a unit tax can be analyzed as a shift in the demand curve facing suppliers or a shift in the supply curve facing consumers, with no difference in the equilibrium prices each faces and the quantity bought and sold. This way of thinking is, to be sure, an important...
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