Papa John and “Passing On”

The response of several businessmen to the upcoming implementation of Obamacare has made quite a splash. Both John Schnatter of Papa John’s Pizza and Denny’s franchisee John Metz announced that the law would impel them to cut employee hours and raise customer prices, which is fair enough.

However, they erred when they both claimed that through such price hikes they would be “passing on” the costs of Obamacare to the consumer. Their error was not only strategic (“Passing on costs to consumers? What heartless, selfish capitalists!”), but conceptual.  Rothbard demonstrated in Power and Market that the notion of such “forward tax/cost shifting” is fallacious:

“The idea that the increased cost will be passed on to the consumer by the employer is an illustration of perhaps the single most widespread fallacy on taxation: that businessmen can simply shift their higher costs forward onto the consumers in the form of higher prices. All the economic theory expounded in this book shows the error of this doctrine. For the price of a given product is set by the demand schedules of the consumers. There is nothing in higher costs or higher taxes which, per se, increases these sched­ules; hence, any change in selling prices, whether higher or lower, will decrease the revenues of the business involved. For each business, on the market, tends to be, at all times, at its “maximum profit point” in relation to the consumers. Prices are already at their point of maximum return for the business; therefore, higher taxes or other costs imposed on the firm will reduce their net incomes rather than be smoothly and easily passed on to con­sumers. We thus arrive at this significant conclusion: no tax (not just an income tax) can ever be shifted forward.

Suppose that a particularly heavy tax—of whatever type—has been laid on a specific industry: say the liquor industry. What will be the effects? As we have noted, the tax will not simply be “passed on” to the consumers. Instead, the price of liquor will remain the same; the net income of the firms will decline. This will mean that returns will be lower to capital and enterprise in liquor than in other industries of the economy; marginal liquor firms will suffer losses and go out of business; and, in general, productive resources of all types will flow out of liquor and into other indus­tries. The long-run effect, therefore, is to decrease the supply of liquor produced, and therefore, by the law of supply and demand, to raise the price of liquor on the market. However, as we have said above, this process—this diffusion of suffering over the econ­omy—is hardly “shifting.” For the tax is not simply “passed on”; it only permeates to the consumers through hurting the industry taxed. The final result will be a distortion of the factors of pro­duction; fewer goods are now being produced than the consumers would prefer in the liquor industry; and too many goods, relatively to liquor, are being produced in the other industry.”

Comments

  1. It is true that there is nothing in higher costs or higher taxes which, per se, increases the demand sched­ule for an industry as a whole. However, they can indirectly change the demand curve for a given firm.

    Let’s say my firm’s Marginal Revenue Product (per hour) for full-time workers is $20, $15, $10, $5, $0. I.e. the 5th worker adds no value (my kitchen is small). Let’s say the market wage is currently $9/hour. So I currently have 3 full-time employees working for $9/hour. Assume the price of pizzas is $5. That means I’m currently producing and selling 9 pizzas per hour, for a total revenue of $45; total labor cost of $27; total revenue net labor of $18.

    After a new tax is introduced, I now have to effectively pay 20% more for labor. So while my employees still only get $9/hour, I pay $10.80/hour. That means I’m going to reduce my workers hours or lay one of them off so that I have the equivalent of only 2 full time employees. Now I’m only producing 7 pizzas per hour.

    If we assume that my firm’s demand curve hasn’t changed, then I’ll be able to raise my price no higher than $6.42. I.e. my total revenue will less than $45. Let’s assume my demand curve is very flat and I can’t raise my price at all. So my total revenue is now $35; total cost of labor is $21.60; total revenue net labor is $14.40. This is an example of the business not being able to pass on the costs.

    But let’s compare that to the scenario if I kept the 3rd employee hired. Total revenue would be $45; total labor cost would be $32.40; total revenue net labor would be $12.60. There is an obvious incentive for me to decrease production immediately.

    There is no need to wait for the long-run effect of lower returns driving marginal firms out of business. In many industries reducing employee’s hours can be done within weeks or even days. In the long run supply will shrink even more. But there is a nearly immediate decrease in supply too.

    Now back to my firm’s demand curve. My firm has a profit motive to decrease production. It is very likely that my competitors have a similar motive. The exact numbers will be different for them. But they will be affected. That means that my firm’s demand curve will become more inelastic than it used to be.

    Rothbard’s analysis really only applies in the short term when the supply “curve” is vertical. But in many industries this short term is very short term. The more variable a firm’s costs, the less time it takes for that firm’s supply curve to change.

  2. I have to agree with Karlsson. A simple counterexample is instructive:

    Say that a pack of cigarettes would sell for $4 in the absence of any kind of tax. In Cook County, Illinois, the tax is almost $6. By Rothbard’s logic, no cigarettes would be sold in Cook County, because the price could not rise enough to cover the added tax. But I know for a fact that people are buying cigarettes at around $10 a pack (the ones who are not buying smuggled smokes, but that’s another issue.)

    • So I’m just saying that a significant amount of cost can be passed on, but agree that it would tend to reduce revenues for the seller. There is some shift of the supply curve that causes a new equilibrium at a higher price but lower volume.

  3. I think that Rothbard forgot in this analysis two things. First, no one starts a business to pay taxes. Thus, one in business needs to know what are the taxes so he can plan ahead. Because to be businessman one has to be a planner, so plan includes all his expenses, which are, among others, taxes. if he fails to estimate his expenses, he may not have funds to invest in his business or even funds to make a livings. So if taxes are raised, their increase HAS TO cut into income of the businessman and he HAS TO increase his revenue. And since his revenue is what he sells, he has to raise it’s price to meet the plan.

    To look at it from another POV: if the goods or services price includes expenses, i.e. cost of resources, work, energy, taxes (payroll, real estate etc), and those expenses determine price, then what is tax increase if not price increase due to expenses increase?

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