Sunday 3 April 2011

Price-elasticity explains who bears a tax.

Ian B recently confused the impact of taxes on cigarettes with the impact of taxes on land, so just to clarify, they are opposite ends of the scale. This has nothing to do with personal or political views (I think that the tax on cigarettes is far too high and taxes on residential land is far too low, others clearly disagree with one or both of these) it is merely a description of how the world works.

Remember that:

a) The demand for housing is price-elastic, i.e. a potential buyer or tenant only has a limited budget and is only prepared to spend a certain proportion of his disposable income on it BUT

b) The supply of residential land and housing is price-inelastic, in other words, the quantity is more or less fixed - no matter how high the price offered in any area, as long as local councils refuse to give planning permission (to keep the NIMBYs happy), supply does not increase. Conversely, if prices offered in another area fall, then values fall without the quantity available falling. In this sense, the land market is quite unique - and this explains why prices vary so widely between different areas, the higher profits from being a landlord in any area cannot be competed away by new entrants.

At the other extreme:

c) The demand for cigarettes is price-inelastic, i.e. smokers hardly reduce consumption when prices go up (which is usually because of taxes). European countries have vastly different rates and (smuggling aside), so the price that smokers pay in different countries pay different amounts accordingly - the tax is 'passed on'.

d) Tobacco companies are reasonably competitive, and as long as they can make a profit they will do so. If demand goes up, they produce more, and if demand goes down, they produce less. And because cigarettes can be easily transported, super-profits can be competed away and prices tend to level out within any jurisdiction. If a government gets too greedy with tobacco duties, then smugglers practice arbitrage between the different rates and total receipts can go down.

The first diagram illustrates how prices are set in the absence of a tax:The second diagram illustrates how imposing a tax on land has a quite different effect to imposing a tax on cigarettes. All you have to do is push the supply line vertically upwards by the amount of the tax and see where it now crosses with the demand line - that's your new equilibrium tax-inclusive price and quantity. The supply of land line is in fact vertical to start with, so pushing it up vertically has absolutely no impact whatsoever on prices charged.This is not idle theory of course, the impacts are easily observable in practice, but the logic is, if a tax is imposed on land values, the quantity available does not change, so the profit-maximising position for landlords is also unchanged and the tax-inclusive price is barely different to the free-of-tax price. If they all try to 'pass on' the tax in higher rents (or selling prices), they would end up with half their buildings vacant and so would end up worse off than if they bear the tax themselves. So while landownership is a cartel, the members of the cartel compete with each other, and no member is willing to leave a building vacant and pay the tax out of no income to enable other members to 'pass on' the tax.

At the other extreme, cigarette manufacturers can 'pass on' a tax quite easily, which is why the tax-inclusive price of cigarettes always goes up by the amount of the increase in tobacco duty which the UK government likes to impose every year, and why tax-inclusive prices are so wildly different in different countries for exactly the same cigarettes produced by exactly the same manufacturer.

Of course, the most damaging kind of tax are taxes on just about anything else, i.e. taxes on normal goods and services being traded in a free-ish market (VAT, income tax, national insurance, corporation tax), where both supply and demand are price-elastic, but I'll leave you to sketch that one out for yourselves - these taxes lead to lower output, hence unemployment, higher prices for consumers and lower profits for producers (not forgetting that most people are producers and consumers, so they lose on both sides, as well as having to pay for all the unemployed people).
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So it is quite possible to distinguish between "economic rents or taxes" on the one hand and "earned income" on the other.

The cigarette companies (ignoring the fact that their industry is just as regulated, i.e. has same barriers to entry as any other and the fact that their product is addictive) just make normal profits, their income net of tax is "earned income".

The tax that consumers pay on top is a tax, or "economic rent" extracted by the government (i.e. it charges it 'because it can' and not because it helps make and sell the cigarettes). Were the government to scrap tobacco duty and cigarette manufacturers to collude to keep prices at about £7 a packet, then this also would be "economic rent" or "privately collected tax" (but the fact that cigarette prices are uniformly lower in countries with lower duty rates suggests they wouldn't be able to).

But turning to my Question 6 of my earlier post (which nobody bothered answering). If you are renting offices from Crown Estates (which belongs to the government) for £1,000 a month and are also paying £400 Business Rates to the government, it is quite artificial to assume that the rent you pay to CE is their "earned income" and that the Business Rates is a "tax" or "economic rent".

The total price you pay of £1,400 is the only relevant amount as far as the tenant is concerned, which consists of the government's "earned income" (the cost of the services which CE provides and notional interest on the bricks and mortar + mark-up) and the "economic rents" they collect (that portion of the total rent which relates to location value, i.e. landlord's quasi-monopoly position).

In an ideal world, Business Rates would be set so that they collect nearly all the "economic rent" (i.e. the extra that a tenant pays for the location value) and allow the landlord to keep all the "earned income" (without paying income tax or corporation tax thereon). Under current rules, Business Rates + income tax might be more and might be less than this, it depends very much on the area (but by and large, they are not a million miles apart).

4 comments:

Bayard said...

"If they all try to 'pass on' the tax in higher rents (or selling prices), they would end up with half their buildings vacant and so would end up worse off than if they bear the tax themselves."

Wouldn't that depend on whether LVT was an additional tax (as it is likely to be), or a repalcement tax? If the latter, the buden of taxation which previously fell more heavily on the tenant will now fall more heavily on the landlord, thus the tenent will have a greater disposable income, therefore the landlord will be able to raise his rent (Ricardo's law). So at the end of the day, the tenant will be no richer and the landlord will be poorer by the amount the gov't is richer.

Mark Wadsworth said...

B, I agree that the calculation is circular - and if income tax cuts are matched by LVT increases £ for £ not much happens (and it was never my intention for much to happen, I want to make things like they are now but 'a bit better').

But the theoretical endgame would be to scrap all taxes on incomes, tax all land rents at 100% and dish it out per capita, then the only difference in people's net incomes (or standard of living) would be down to how much they earn from productive work (or wise or lucky investment in wealth creating assets etc) and NOT rents which accrue to them from their govt. protected monopoly positions.

So the clock is constantly re-set to zero, instead of some classes moving inexorably upwards and others running to stand still (the 'landless peasant' class).

And paring back the amount that the government raises in tax and spends on itself (obviously, public sector salaries are another form of govt. protected monopoly position) is a worthy aim in itself and worth doing independently of how taxes are raised.

James Higham said...

It's the availability of new housing areas which is the bottom line here, no?

Mark Wadsworth said...

JH, that is one factor affecting supply (taxation, and hence efficient use of existing stock is the other, and possibly more important one).

More important is credit availability, which has a huge impact on demand (shifts curve upwards).

Wherever the two curves cross determines the price.