|Monday, February 04, 2013||(Comment)|
How income tax feeds into prices
Perhaps the easiest way to explain the price effect of income tax is to compare it with the “value-added” tax (VAT) — also known as the GST. Under a “value-added” tax, the value added by the labour of a firm’s employees, as measured by their wages and salaries, is taxed in the hand of the firm, not in the hands of the employees. Hence wages and salaries are not deductible from the firm’s taxable “value added”; that is, there are no input credits for wages and salaries. But under an “income” tax, the value added by the employees is taxed as “personal income” while the value added by the firm’s assets (that is, its profit) is taxed as “corporate income”. Hence wages and salaries are deductible from the firm’s taxable “income”. In summary, an “income” tax is a value-added tax except that the taxable value added is split between the firm and its employees, and the part attributed to the employees is called personal income while the part attributable to the firm is called corporate income. So, as no one denies that a “value-added” tax feeds into prices, how can anyone deny that an “income” tax feeds into prices?
One might answer that a “value-added” tax is border-adjusted, so that a VAT taxes the consumption of imports but not the production of exports, whereas an income tax does the reverse. In other words, while the price effect of the VAT falls entirely on domestic consumers, the price effect of the income tax falls on domestic and foreign consumers of domestic production, and is circumvented by domestic consumers of foreign production. But imports account for only part of the cost of living. Moreover, because income tax adversely affects the balance of trade, it causes a lower currency value, which partly offsets the price advantage of imported products.
So, as far as consumers are concerned, border-adjustment is a minor detail, and income tax is essentially a VAT by another name.
In Australia, certain products, such as fresh food, are free of GST. These products are cheaper than they would be if the GST applied to them. But the same thing could be done with income tax. If employees in the fresh-food industry were exempt from personal income tax, labour would be attracted into that industry until competition reduced gross wages in the untaxed industry to a level competitive with net wages in taxed industries. If the companies producing fresh food were exempt from income tax on their profits, investment would be attracted into the fresh-food industry until competition reduced gross profits in the untaxed industry to a level competitive with net profits in taxed industries. Lower wages and lower profits would imply cheaper fresh food.
And yet, while it was a political necessity to make fresh food GST-free, nobody suggested that the producers of fresh food, or of any other necessity of life, should be exempt from personal or corporate income tax, because not enough voters knew how income tax affects prices. What the voters didn’t know wouldn’t hurt the politicians.
Of course, to say that an “income” tax, like a “value-added” tax, feeds into prices is not to say that the whole of the tax is added to prices. It is merely to say that, for the same amount of revenue, the two taxes affect prices to a similar degree. An income tax on wages will be borne partly in higher prices and partly in lower net wages. An income tax on profit will be borne partly in higher prices and partly in lower net profit. Adding the two together, we conclude that a value-added tax is borne partly in higher prices and partly in lower value-added.
[Extract from an article at Prosper Australia, Jan.26, 2013.]
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