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Do the Laws of Tax Incidence Hold? Point of Collection

and the Pass-through of State Diesel Taxes

Wojciech Kopczuk (Columbia)

Justin Marion (UC Santa Cruz)

Erich Muehlegger (Harvard)

Joel Slemrod (Michigan)

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• Tax administration is often ignored in public finance despite the fact that the resource cost of collecting taxes is (in the US) on the order of 10% of revenue and noncompliance is 15% of taxes due.

• However, it may affect the structure of tax systems and the size of government, distribution, and efficiency.

• Today: the impact of the point of tax collection

• “Law” of tax incidence:

Statutory incidence is irrelevant for economic incidence.

• We assert that this law may not hold if the ability to comply/evade differs across points of collection.

This paper: First (?) to test empirically the independence of economic incidence

Introduction

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• Focuses on the market for diesel fuel. Why?

--Remitting party (point in supply chain) differs across states and over time

--Evasion is a potentially important part of the market

--The opportunities for evasion different across levels of supply chain

• We’ll examine the pass-through of taxes into retail prices, and then connect this to evasion through tax collections

This paper…

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• In states where the responsibility for remittance is high in the supply chain (distributor or prime supplier):

1. Retail price is higher

2. Pass-through rate of taxes to retail prices is higher

3. Tax collections are higher

• Can trace the effect through the supply chain

• To obtain these results, we exploit the timing of state policy changes regarding the point of collection.

Preview of results

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Why does evasion affect pass-through?

• Rents from evasion increase with the level of the tax:

• As taxes rise:

• Evasion rents subsidize losses on legal sales.

• Less exit occurs than in the case of full compliance.

• With heterogeneity in fixed cost and the rents from tax evasion, tax-compliant firms are disadvantaged relative to tax-evading firms.

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• Generates an upward-sloping supply curve

• A higher tax rate affects firm composition, as it favors those firms with a high capacity to evade.

• Pass-through to consumers is no longer sufficient to identify incidence, as a tax change affects firm rents as well.

• In sum, reducing tax evasion has multiple effects from the point of view of the industry.

– It creates winners and losers among firms. (Why do firms want to be remitters?)

– The effect on the overall profits in the industry is in general ambiguous and depends on the relative amount of tax evasion pursued by average versus marginal firms.

Implications of heterogeneity

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• If one shifts the point of taxation to a higher cost-of-evasion point in supply chain:

• p rises, pass-through rate (relative to statutory tax rate) rises

• Total production, q, falls

• Reported gallons, q − e, rise

• In the paper the model is extended to have multiple production/distribution stages with different evasion technologies.

Summary of model results

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• Supply chain

Refined fuel stored at terminal rack (Prime supplier)

Offloaded by wholesale distributor (aka “jobber”)

Retailer takes delivery from wholesale distributor

• 1,343 active bulk fuel terminals and 855,915 retail gasoline station

establishments

• No. 2 distillate

Diesel used in vehicles

Fuel oil used in home heating and industrial processes

Chemically equivalent aside from differing content regulations for

on-highway use (sulfur)

• Diesel taxes: currently 8-46.2 cents per gallon across states, 24.4

cents per gallon federal

Setting – Fuel markets

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• The party responsible for remittance varies considerably over time and across states.

• Federal level:

1988: Retailer → Wholesaler

1994: Wholesaler → Prime supplier (bulk terminal)

• State level:

In our time period, 8 states switched from retailer to distributor collection, 5 from retailer to prime supplier, 1 from distributor to retailer, and 15 from distributor to prime supplier. No state switched away from supplier collection.

Tax collection

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Point of Diesel Tax Collection, 1990

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Point of Diesel Tax Collection, 2004

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1. Underreporting tax liability by misstating sales

Monitoring is easier if collected from higher in the supply chain

2. Claim intended use as untaxed purpose, then sell at tax-inclusive price

Dyeing program, beginning in 1993, made more difficult, but dye removal, offloading without adding dye, masking dye color are all possible.

3. Take advantage of inter-jurisdictional tax differentials.

Note: Upstream remittance is best for type 1 evasion, downstream is best for type 2 and 3. But, the dyeing program facilitated upstream enforcement of type 2 evasion.

Diesel fuel tax evasion

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• Price data

The ideal data set would provide price paid by wholesaler to terminal, retailer to wholesaler, and consumer to retailer.

We only observe retail price.

Monthly 1986-present for select states (mostly Northeast, Mid-Atlantic, Midwest)

• Quantity data

Annual taxed gallons by state, 1986-present

Data

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• Use within-state variation in point of collection

• Examine effect on retail prices

→ Shifts in pass-through higher up the supply chain reflected in downstream prices

pit = β0 + β1 τit + β2regimeit + β3 τit ∗ regimeit + BXit + ǫit

• regime it are indicators for collecting tax from wholesaler

or terminal (retailer collection is left out).

• Xit includes state economic conditions, state and year-month effects, minimum of tax rate in neighboring states, et al

• Retailers report price excluding taxes

• Allow pass-through rate to vary by year

Research design

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(1) (2) (3) (4)

Real diesel tax

-0.086 (0.021) ***

-0.025 (0.022)

-0.120 (0.055)**

-0.098 (0.071)

Collect from terminal

2.875 (0.268)***

0.445 (0.604)

0.824 (0.658)

Collect from distributor

1.378 (0.188)***

0.192 (0.626)

-0.308 (0.656)

Real tax*collect from terminal

0.209 (0.052)***

0.162 (0.057)***

Real tax*collect from distributor

0.100 (0.056)*

0.139 (0.057)**

Tax-exclusive Retail Price Results

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• Nearly, but not all (91.4%), burden borne by consumers.

• Supplier-remit states have a retail price 2.88 cents higher than retailer-remit states; 1.38 cents higher in distributor-remit states.

• Column (3) suggests that the pass-through rate rises as the tax collection point is moved up the supply chain.

• In column (4), a full set of year-by-tax interactions is included, to allow for the rate of pass-through to vary over time. This has little effect on the estimated parameters of interest.

Interpretation

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• The remitting party is set endogenously by the state, which raises two two issues:

Choose to collect tax from party yielding highest revenue

(heterogeneous treatment effects)

Collection regime chosen in response to unobserved factor that is also correlated with evasion or pass-through

• Issue 1 suggests that the estimated effects are local, not average

• Null hypothesis of independence of incidence can still be tested under issue 1

• Issue 2 potentially more serious; we examine it with several tests.

Endogenous policy

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• Next we try to connect the incidence results to direct evidence of evasion

• How does the point of tax collection affect the ability to evade?

• Assumption: An increase in tax collections after changing point of collection is due to a reduction in evasion, i.e. there are no real effects

• Utilize timing to distinguish from underlying forces driving both tax collections and point of taxation

• Estimate three types of regime changes on tax collections, indexed by j

Retailer-to-distributor

Retailer-to-supplier

Distributor-to-supplier

Δln(qit) = α0 + α1Δln(pit) + α2Δln(1+τit/pit) + Σαjdjit +AΔXit +γt +ǫit

where d is a dummy variable for whether a given transition took place.

• Demand assumed to be a function of tax-inclusive price p + t

Tax collection and evasion

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(1) (2) (3)

Retailer to distributor

0.073 (0.044)

0.081 (0.050)

0.080 (0.051)

Retailer to supplier 0.078 (0.039)*

0.072 (0.035)*

0.069 (0.030)*

Distributor to supplier

0.015 (0.033)

0.009 (0.033)

0.005 (0.030)

Log price -0.384 (0.161)**

-0.459 (0.170)***

Log (1+tax rate) -0.456 (0.269)*

-0.625 (-.306)**

Results for taxed gallons

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• Upstream shifts in the point of tax collection away from the retailer are associated with a higher reported tax base.

• No significant effect of moving from distributor to supplier as point of collection.

• In Column 2, adding a number of covariates does not affect the estimated effect of regime change. Note that reported sales are more elastic with respect to the tax rate term than to the pre-tax price term.

• Column 3 includes a control for the lagged dependent variable, which attracts a negative estimated coefficient, likely reflecting a end-of-year reporting phenomenon.

Interpretation

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• We consider how the pattern of tax-inclusive prices and tax revenue may depend on the point of collection.

• In diesel markets, there is greater pass-through when collecting from the wholesale distributor or prime supplier.

• We find evidence in support of collection-point-varying tax evasion, as tax revenues rise when moving collection to the wholesaler or the prime supplier from the retailer.

• One lesson of the research is that, because firms are central to tax collection, tax analysis needs to be integrated with IO analysis.

Conclusions