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 Tax Incidence: Who Pays? The Incidence of Payroll Taxes

In 2003, 40 percent of federal revenues came from social insurance taxes, or payroll taxes. Their revenues support Social Security, unemployment compensation, and other health and disability benefits. Some payroll taxes are levied on employers, some on workers.

To analyze the incidence of the payroll tax, look at the graph below:

Assume that the tax is paid by the employer. The original wage before the tax is Wo and the original number of workers hired is Lo. The payroll tax causes the labor supply curve to shift above the old labor supply curve by the amount of the tax. The new curve S’ is labor supply as a function of what firms pay. Firms pay Wo + T per unit of labor after the tax is levied. At this higher cost, firms demand LD. Workers still receive Wo so workers still supply labor at Lo. The excess supply puts downward pressure on wages, and they fall to W1. At this wage, L1 units of labor are supplied and demanded and the market clears.

In this case, the burden of the payroll tax is shared by both employers and employees. The worker's burden is (W1 – Wo) x L1. The firms’ burden is (W1 + T) – Wo) x L1. The tax revenues generated are T x L1. The relative size of the firm’s share and the workers’ share of the total tax burden depends on the shapes of the demand and supply curves. Workers bear the bulk of the burden of a payroll tax if labor supply is relatively inelastic, and firms bear the bulk of the burden of a payroll tax if labor supply is relatively elastic. Empirical studies of labor supply behavior in the United States suggest that for most of the work force, the elasticity of labor supply is close to zero, so most of the payroll tax burden is probably borne by workers. See Figure 16.4.

To futher explore the incidence of taxes, try the following Active Graph exercise:

Active Graph Level 2: Using Elasticity: Analyzing the effect of an excise tax

and the following Active Graph exercise:

Active Graph Level 1: Tax Incidence and Elasticity

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