July 31, 2010

If the government doesn’t earn it, who does earn the money the government spends?

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We the People of the United States, in Order to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defence, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity . . . .

The Constitution of the United States, Preamble

You earn the money the government spends. The only way the government can obtain money is through taxation, and regardless of whom the government claims it is taxing, ultimately, the people pay all of the taxes.

A common misconception is that both people and companies pay taxes to the government. This is false. While the government certainly collects taxes from companies, people ultimately pay those taxes.

Consider a shoe store that sells a pair of shoes for $100. Suppose that there is no government and so no taxes of any sort. Suppose further that of the $100 the store receives for the shoes, $50 go to the manufacturer who made the shoes, $20 go to various companies to pay for overhead (rental on the floor space, racks, display cases, electricity, phone service, etc.), $15 go to the store’s employees, and $15 go to the stockholders and bondholders who invested the money to create the business. Now, suppose that a government springs into being and begins taxing the shoe store $5 per pair of shoes sold.
There are only four things the shoe store could do to pay the tax.

  1. The store could charge $5 more for the shoes.
  2. The store could pay its stockholders and bondholders $5 less in dividends and interest,
  3. The store could cut its employees’ pay by $5, or
  4. The store could negotiate with the manufacturer or the various firms to cut $5 off the price of the shoes or the overhead.

There is no other way the store can come up with the $5 tax. The store must do one (or a combination) of these four things.

Observe who pays the tax in each of these four cases. If the store increases the price of the shoes by $5, then the store’s customers will have paid the tax. Yes, the government would collect the tax from the shoe store, but if the store raises the price of its shoes $5 in response to the $5 tax, then the customers are actually paying the tax. If the store pays its stockholders and bondholders $5 less, then the stockholders and bondholders will have paid the tax. If the store pays its workers $5 less, then the workers will have paid the tax. If the store negotiates a lower price from the manufacturer or lower rental from the landlord, then the manufacturer or the landlord will have paid the tax. In each case, it appears that someone other than the shoe store pays the tax. People either pay taxes directly, or they pay indirectly through higher prices, lower returns on investments, or lower wages. Even taxes that companies pass on to other companies, as in the case of the shoe store negotiating a reduced price from the manufacturer, are paid by people because those companies will pass the tax on to their customers, investors, or workers.