Front Page Titles (by Subject) The Theory of Tax Incidence - Cost and Choice: An Inquiry in Economic Theory, Vol. 6 of the Collected Works
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The Theory of Tax Incidence - James M. Buchanan, Cost and Choice: An Inquiry in Economic Theory, Vol. 6 of the Collected Works 
The Collected Works of James M. Buchanan, Foreword by Geoffrey Brennan, Hartmut Kliemt, and Robert D. Tollison, 20 vols. (Indianapolis: Liberty Fund, 1999-2002). Vol. 6 Cost and Choice: An Inquiry in Economic Theory.
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The Theory of Tax Incidence
The theory of tax incidence commands a lion’s share of attention in neoclassical public finance, especially among English-language scholars. A cursory examination of this literature suggests that the aim is to answer the questions: Who pays for public goods and services? Who bears the final burden of payment under specified tax instruments? How does the allocation of “cost” or “burden” differ under different taxes?
The two words “cost” and “burden” seem to be used almost interchangeably. The presumed objectivity of these magnitudes has more or less been taken for granted. The revenues collected by the treasury can, after all, be counted. Someone must be subjected to this “cost”; someone must release command over purchasing power which represents, in its turn, real resources. Certain taxes generate “excess burdens” over and above the actual revenue collections, but these, too, are objectively quantifiable, at least conceptually. There has been little or no attention paid to the possible relationship between taxes as the costs of public goods and taxes in choices for public goods.
Shifting and incidence analysis examines the choice behavior of individuals and firms, but this is not the choice behavior that involves either the financing of public goods or the selection among taxing alternatives. The individual or firm is assumed to be subjected to an imposed change in the alternatives of private or market choice. Here, taxes can affect cost in a choice-influencing context, and, indeed, incidence theory would be empty if this were not the case. Consider the familiar benchmark, the lump-sum tax. No shifting takes place here; incidence is not in question. But surely there is a “cost” of public goods borne by individuals, and “choice” must be made. Contrast this with an excise tax, say, on liquor. Here the tax, if shifted by the seller, modifies the alternatives that the prospective buyer confronts, because the “cost” of buying liquor increases. It is here that the predictive or positive theory is at its strongest. Since both the object of consumption and the numeraire can be readily identified as “goods” in the individual’s utility function and since, before the tax, the individual’s rates of purchase for all “goods” could be assumed to be in equilibrium, the objectively measurable increase in cost, as reflected in the tax-induced price rise, can be seen as representative of the increase in subjective cost that actually inhibits consumer choice for the taxed commodity. It is erroneous, however, to relate the tax-induced increase in a consumption-goods price—hence, in its “cost” to the buyer—with the wholly different “cost” of the public good which the tax revenues somehow represent. This leads us back to the initial questions. As traditionally developed, does incidence theory really aim at locating the cost of public goods? Orthodox tax-shifting and incidence analysis is concerned almost exclusively with tax-induced changes in the costs of undertaking private activities of production, investment, and consumption and with predictions of the effects of such changes on behavior.
If the analysis yields no information about the costs of public goods, what value does it have for anyone? If the economist can with confidence trace the full effects of a tax, he is able, presumably, to array this tax against others on some postulated scale of equity or efficiency. In this task, he conceives his role as that of advising the decision-maker, hence indirectly influencing the choice that is made among tax instruments. This seems straightforward enough until the sometimes weird results of presuming the objective measurability of cost are recognized. In assessing the consequences—or predicted consequences—of a tax levy, is the economist seeking to determine the measurable changes in the values of empirically descriptive variables such as prices, quantities, and employment levels? Or is he seeking to determine the individuals’ evaluations of these changes?
Consider a simple example. Suppose that the pre-tax price of liquor is $10 per bottle and that an individual is observed to purchase 10 bottles per year for a total outlay of $100. A specific excise tax of $1 is imposed; the retail price is observed to rise by the full amount of the tax to $11; and the individual’s annual rate of purchase falls to 9 bottles, for an annual outlay of $99. Assuming a linear demand curve over the relevant range, the economist says that the “burden” of the tax is computed at $9.50, with $9 being channeled through to the treasury and 50¢ being an “excess burden.” On familiar grounds, the individual is simply assumed to “prefer” a lump-sum tax that would require him to pay only $9. On “welfare” principles, therefore, the economist suggests the desirability of the lump-sum tax as a substitute for the excise tax.2 To reach this conclusion, the economist must assume that the taxpayer is exclusively interested in the post-tax changes in his position and that he is indifferent among tax instruments otherwise. But there are obviously many reasons why the taxpayer may not evaluate alternative tax instruments in the same way that the applied welfare economist evaluates them. The taxpayer might, in the first place, prefer to suffer the higher measurable cost imposed by the excise tax because of the wider range of personal options that this form of tax allows. This option feature may well outweigh the excess burden. In the second place, the taxpayer may prefer the excise tax on liquor for sumptuary reasons even though he knows that he, too, bears an excess burden. The tax-induced reduction in liquor purchases by others may be more than enough to modify the relative standing of this tax on his preference scale.3
Even if the applied economist is uninterested in the evaluations of taxpayers in any sense relevant to their possible participation in fiscal choice and relies instead on an externally derived “social welfare function” in establishing his array of tax instruments, the difficulties raised above do not disappear. He would be hard put to defend the objectively measurable “cost” emerging from the orthodox tax-shifting analysis as a criterion for arraying tax devices if such a “cost” did not in some way relate to individuals’ own reactions and evaluations.
[2. ]I am not concerned here with various modern qualifications on this proposition, all of which derive from some version of second-best limitations. My criticism holds even if all of the welfare conditions are fully satisfied elsewhere in the system.
[3. ]In an earlier work, I have tried to relate the effects of different fiscal instruments on the individual’s behavior in fiscal process. See my Public Finance in Democratic Process (Chapel Hill: University of North Carolina Press, 1967). See also Charles Goetz, “Tax Preferences in a Collective Decision-Making Context” (Unpublished Ph.D. dissertation, Alderman Library, University of Virginia, 1964).