The Incidence of the Payroll Tax
The payroll tax may be thought of as an excise tax on the employment of labor. The U.S. payroll tax comes in two parts: half is levied on the employees (payroll deductions) and half on employers. A fundamental point, which people who have never studied economics often fail to grasp is that:
The incidence of a payroll tax is the same whether it is levied on employers or on employees.
A simple numerical example will illustrate why this is so. Consider an employee earning $100 a day with a 16 percent payroll tax that is shared equally between the employer and the employee, as under our present law. How much does it cost the firm to hire this worker? It costs $100 in wages paid to the worker plus $8 in taxes paid to the government, for a total of $108 a day. How much does the worker receive? He gets S100 in wages paid by the employer less $8 deducted and sent to the government, or $92 a day. The difference between wages paid and wages received is $108 - S92 = $16, the amount of the tax. . Now suppose Congress tries to “shift” the burden of the tax entirely onto firms by raising the employer’s tax to $16 while lowering the employee’s tax to zero. At first, the daily wage is fixed at $100, so firms’ total labor costs (including tax) rise to $116 per day and workers’ net income rises to $100 per day. Congress seems to have achieved its goal.
But the achievement is fleeting, for this is not an equilibrium situation. With the daily cost of labor at S116 for firms, the quantity of labor demanded will be less than when labor cost only $108 per day. Similarly, with take-home pay up to $100 for workers, the quantity of labor supplied will be more than when the after-tax wage was only $92. There will therefore be a surplus of labor on the market (an excess of quantity supplied over quantity demanded), and this surplus will put downward pressure on wages.
How far will wages have to fall? It is easy to see that an after-tax wage of $92 will restore equilibrium. If daily take-home pay is $92, labor will cost firms $108 per day, just as it did before the tax change. So they will demand the same quantity as they did when the payroll tax was shared. Similarly, workers will receive the same $92 net wage as they did previously; so quantity supplied will be the same as it was before the tax change. Thus, in the end, the market will completely frustrate the intent of Congress.
The payroll tax is an excellent example of a case in which Congress, misled by the flypaper theory of incidence, thinks it is “taxing firms” when it raises the employer’s share and “taxing workers” when it raises the employee’s share. In truth, who is really paying depends on the incidence of the tax. But no lasting difference results from a change in the employee’s and the employer’s shares.
Who, then, really bears the burden of the payroll tax? Like any excise tax, the incidence of the payroll tax depends on the elasticities of the supply and demand schedules. In the case of labor supply, there is a large body of empirical evidence pointing to the conclusion that the quantity of labor supplied is not very responsive to price for most population groups. The supply curve is almost vertical, like that shown in Figure 33-8. The result is that workers as a group are able to shift little of the burden of the payroll tax.
But employers can shift it in most cases. Firms view their share of the payroll tax as an additional cost of using labor. So when payroll taxes go up, firms try to substitute cheaper factors of production (capital) for labor wherever they can. This reduces the quantity of labor demanded, lowering the wage received by workers. And this is how market forces shift part of the tax burden from firms to workers.
To the extent that the supply curve of labor has some positive slope, the quantity of labor supplied will fall when the wage goes down, and in this way workers can shift some of the burden back onto firms. But the firms, in turn, can shift that burden onto consumers by raising their prices. Prices in competitive markets generally rise when costs (like labor costs) increase. It is doubtful, therefore, that firms bear much of the burden of the payroll tax. Here, the flypaper theory of incidence could not be further from the truth. Even though the tax is collected by the firm, it is really borne by workers and consumers.
