Tax Rascal

# Who Really Pays Sales Taxes?

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That’s actually a fairly complicated question. From an accounting standpoint, you’re paying all of the taxes. But from an economic standpoint, the question of who pays the taxes depends on the elasticity of the product.

Elasticity refers to how use responds to price changes. For a product that’s competing directly with lots of other, similar products, elasticity is very high: if a gas station raises their prices 5%, but the one across the street keeps prices constant, nearly all of first station’s customers will desert it.

But for a low-elasticity product, the opposite is the case. If you consider an addictive product (like cigarettes or alcohol), or a cheap product that you have to buy repeatedly to make an expensive product work (movies for your big screen TV and surround-sound system; replacement razor cartridges), changes in price don’t make a big difference. Smokers might complain, but they wont kick the habit over a 10% increase in cost; similarly, you won’t let your \$4000 entertainment system go to waste because your Friday night movie rental costs \$1 more.

What economists have found is that when there’s a sales tax, normal spending behavior is distorted. If there’s a 10% tax on gas that costs \$3.50 per gallon, producers produce (and profit) as if it cost \$3.50 per gallon — but consumers buy it as if it cost \$3.85 (10% more). So, producers produce a little less than they otherwise would, and consumers buy a little less than they otherwise would. Some of that lower total production is made up for by the tax revenues, but the total value of the gas sold plus taxes received is always less than the total value of the gas sold with no taxes.

Now, we can apply that to your question: who *really* pays a sales tax? The answer: for elastic goods, the seller pays. For inelastic goods, the buyer pays. How does that work? Think of cigarettes. Imagine that they cost \$4 per pack without taxes. Then consider what happens when a \$1 tax is added. Producers still produce like cigarettes cost \$4, but buyers now buy as if cigarettes cost \$5. Of course, this price increase would lead to only a tiny decrease in the number of smokers or the amount that they smoked. If almost everyone is smoking just as much, they’re paying 20% more to do it, and the seller is basically unaffected — it’s clear that the consumer pays most of the burden.

Now let’s consider another scenario. Let’s imagine that lawmakers decide that a big oil company has been price gouging, and, for whatever reason, declare that its penalty will be to pay an extra 5% gas tax. If the company just raises prices — even by a mere 5% — most of their customers will simply buy gas from other gas stations. There may be a few places where customers don’t have that option, but for the most part being the only commodity seller to sell for 5% more than anyone else is a bad deal. So the company will have to cut prices, to keep their prices in line with that of the competition. But if the company cuts prices and still pays the sales tax, where does the tax revenue come from? Clearly, it comes out of the company’s profits — they have to act as if gas was worth about 5% less than consumers are paying, so they produce less, at a lower profit.

These are all fairly contrived examples, but I think they illustrate a pretty complex topic in a simple way: the real ‘payer’ of a sales tax isn’t the buyer, and it isn’t the seller — it’s whoever has the least freedom to respond to price changes.