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Effect of Taxes on Production Upon Supply, Demand, And International Trade

( Originally Published Early 1900's )

THE general policy of different forms of taxation, that is, the consideration of the effect of taxes upon the interests of society, belongs to the application rather than to the theory of economics. At the same time, a tax levied by government is an economical cause, the effects of which are to be investigated by the same methods that we employ in the investigation of other causes. The consideration of taxes is there-fore a legitimate branch of pure economics, which we shall now enter upon so far as necessary for the purpose of rounding out the subject.

The only taxes which we need consider for the present purpose are those levied upon production; that is, the taxes which a producer may be obliged to pay as a consequence of having added to wealth. Since transportation is an act of production, it follows that import duties are to be included in our list. As a matter of fact, import duties are the only taxes upon production which are at all popular. But most governments are obliged also to levy taxes upon particular home products, especially alcoholic liquors and tobacco. All such taxes produce their effect through the laws of supply and demand, and the method of investigation is the same in all.

To begin with a simple case, let us suppose that a country has, up to a certain point, had no occasion to levy a tax upon tobacco. A necessity for increasing the revenue arises, and the government determines to levy a tax on all tobacco produced. Let this tax be fixed by a percentage of the value of the tobacco, and, for convenience, let us suppose it to be payable when the tobacco is produced.

Now, the first conclusion we draw is that the immediate economic effect of the tax is the same as that of an increase in the cost of producing tobacco. For, so far as the producer of tobacco is concerned, it makes rio difference to him whether the money which he pays goes as tax to the government, or to some land-owner or laborer who helps him in his work. In both cases it is a sum which he has to pay out as a condition of producing, and is therefore regarded by him as an addition to the cost of production. The question now is, What change will this tax produce in the supply and the demand ? The first factor in the case will be the producer, with whom therefore we commence to trace out the effect.

It is certain that the first thing that the producer will at-tempt will be to add the tax to the price at which he sells his tobacco. This addition must be made by all through whose hands the article passes, and thus the consumer of tobacco will find an attempt to charge him a higher price for it. Now two cases may occur, depending on whether tobacco is or is not an insensitive commodity.

If tobacco is an insensitive commodity ( 15), that is to say, if the consumer will buy as much at the higher price as he formerly bought at the lower price, then no further change will occur in the conditions. The manufacturer and seller of the tobacco, finding this same demand under the increased price as they did before the tax was levied, will go on manufacturing the same quantity as before, and will make the same net profits. We may therefore lay down the law:

A tax upon an entirely insensitive product is wholly paid by the consumer, no matter what the conditions of production.

But the case of an absolutely insensitive product is an extreme one, which we can hardly consider to have an actual occurence. It is certain that some people will economize in the use of tobacco or any other product when the price is high. Then when the seller finds the amount demanded to fall off in consequence of the increased price, we have a cause which we must trace back to the producer. The consumer buying less, the producer finds that he cannot sell the saine amount as before. He must therefore do one of two things : (1) diminish his production, or (2) lower his price, thus taking a part of the tax upon himself. Which course he will take depends upon the conditions under which he produces, and especially upon whether monopolized elements enter into the production.

If there is no monopoly, then it is to be assumed that, before the taxes were levied, the competition of producers had resulted in the tobacco being sold at the lowest price which would induce any person to engage in its production. This being the case, the producers could not all afford to go on producing as before, and still pay a part of the tax. There must there-fore be a diminution, those least able to bear the additional burden going out of business, and the others diminishing their production. This diminution must, in the case supposed, go on until the rise in prices caused by the increased scarcity be-comes nearly equal to the tax. We have therefore as a second law:

The tax levied upon a commodity into which no monopolized elements enter is entirely paid by the consumer.

Suppose next that a monopolized element does enter ; for example, that certain soils are much better adapted to raising tobacco than to any other purpose, and would command a much higher rental than they would if the production of tobacco were stopped. If the cultivators of such soils leave off raising tobacco, they will be subject to a greater or less loss of income. Therefore rather than do so they will lower the price ; that is, they will pay a portion of the tax themselves. To correspond to the actual case we must suppose a graduated monopoly, some soils having no special advantage in raising tobacco, and others having a great advantage. The former will now be devoted to the cultivation of some other product when the tax is levied, while the owners of the latter will pay a portion of the tax. We therefore reach the conclusion :

A tax upon a sensitive commodity into which monopolized elements enter is divided between the producer and the consumer.

A fourth case may be considered possible, namely, that in which a consumer will not pay any increase of price whatever. Let us then suppose that, from any cause, when the seller of tobacco raises the price, he finds that his customers will not buy any at all, and that he must either continue to sell at the old price or go out of business. The knowledge of this fact will go back through the channels of trade to the producer, who must then take his chance of selling at the same price as before or giving up production. If he can better afford to pay the whole tax than to go into some other business, he will do so. If he cannot, he must stop producing tobacco entirely. Hence we have a fourth law :

If a commodity cannot be sold at all above a certain price, a tax upon it must be paid entirely by the producer.

This case can hardly arise unless a commodity is very sensitive in consequence of some substitute for it being readily obtainable. Then if this substitute is untaxed, the effect of the tax may be to stop the production of the taxed commodity entirely.

67. Taxes on International Trade. If an import duty be levied, the home and foreign production of the article imported will be changed in accordance with laws founded on those first principles which have just been enunciated. A much greater complexity of circumstances may, however, enter, depending upon the variety of sources from which both the foreign and domestic supply of the commodity may be obtained. In domestic taxation we had to consider only a single class of producers, or at most a single graduation of the monopoly. But most largely imported products may be obtained from several countries, where they are produced under very different conditions; we must therefore see how the preceding principles will apply to these various conditions which may be found to exist. If there were a commodity C which could be produced only in England, and which none but Americans consumed, then an import duty levied by America upon C would either be paid wholly by American consumers, or divided between the American consumer and the British producer in exact accordance with the laws already laid down. That is, the tax on an insensitive product, or on a product of which no producer in England had any monopoly, would be paid entirely by the American consumers. As the product, on the one hand, became sensitive; or, on the other hand, as the production was monopolized, the British producer would have to lower his price in order to induce the Americans to continue their importation.

This simple case is, however, an extreme one. As a matter of fact almost every commodity can be and is, to a greater or less extent, produced by ourselves. This fact brings in a case which cannot arise in domestic taxation, namely, that of an untaxed home product competing with the taxed foreign product. Hence the laws governing the case will be more complex than in the case of domestic taxation.

A yet further difference in the two cases arises from the fact that the British producer has other nations to whom he can sell, and who perhaps do not levy the same tariff that the United States does. To show how these two differences modify the result, let us take the case of writing-paper. Suppose that under free trade a certain amount Q of writing-paper would be annually imported from abroad and a certain other quantity H produced at home. Let a duty then be levied upon the foreign paper. We may suppose that the foreign manufacturer would at first endeavor to throw the payment of the entire duty upon the American consumer. The latter would then be charged a higher price for his paper. The result would be an attempt on his part to economize in the use of paper and to prefer the domestic product. The immediate result would therefore be an increased demand upon the American manufacturer for paper. This would lead to a rise in the price of the home product. The effect of this upon home production would depend upon the extent to which monopolized elements enter into the manufacture of paper, the effect being determined by the laws already laid down in treating of monopolies.

If no monopoly either in skill or material existed, so that large numbers of men could make paper as advantageously as the most experienced makers, then this higher price would stimulate the manufacture of paper. The rise in the price would be checked, and the American consumer, getting his supplies at home, would greatly diminish his demand for the foreign product.

We must now trace the reaction of this diminished demand upon the foreign producer. If no monopolized elements enter into the foreign product, then the foreign producer, making no more than the regular profit, could not afford to lower his price in order to stimulate the declining demand. If he had no demand except what came from America, those who were least able would have to go out of business, as in the case of home taxation. Just here, however, the difference arises. The English manufacturer has not only America, but his own country and the rest of the world, as possible buyers of his product. Hence by lowering the price in a degree very slight compared with the duty, he may recover from other sources of demand what he has lost in the American demand. He will not there-fore be obliged to bear any considerable portion of the tax levied by .America. This conclusion may be generalized as follows :

If the greater part of the supply of some special commodity produced in one country is consumed in another country, then a duty levied by the consuming country may have to be partly borne by the producer. But in the more common case in which there are many home and foreign consumers of the commodity, then either a duty levied must be paid entirely by the consumers of the country which levies the duty, or the importation of the commodity must cease.

The effect just described upon the . foreign producers was deduced on the supposition of a non-monopolized home production. If, however, the home production is monopolized, then the increased home demand consequent upon the duty will not be entirely met be increased home production, but by increased home price. The owners of the monopolized elements will be able to command a higher price for their services. The consumer will therefore have to pay a higher price whether he purchase the home or foreign product. For a yet stronger reason than before, the foreign producer will have no motive for materially diminishing his price. One result will be a diminution in the consumption of paper; another will be an in-crease in the ability of the home producer to command a price for his monopoly.

We thus see that an import duty upon products into which monopolized elements enter gives an immediate value to those elements which they would not otherwise have. Suppose, for example, that in consequence of inherent capacity and natural aptitude I have acquired a peculiar skill in making a very elegant style of paper at a very small cost to myself. So long as I am subject to the competition of equally gifted foreigners I may be unable to command more than a moderate price for my paper. If, however, I can induce the government to levy an import duty on this particular kind of paper which I alone in this country can make to the best advantage, then I can raise the price either to the highest limit which people are willing to pay, or to the cost of production by less favored persons. That is, by the aid of the tariff I shall be able to command for my skill a higher price from my fellow-citizens who want the paper, while my government may not be able to collect any increased revenue from foreign importations, because the diminution of imports may compensate for the increase of duty.

If, on the other hand, there are an unlimited number of my countrymen who are as well qualified to make this peculiar paper as I am, then a tariff will not benefit me, since, in any case, I am then subject to unlimited competition.

Effect of Import Duties on the Balance of Trade. From the considerations in the last chapter it follows that international trade is determined by production and relative prices in the two countries, combined with cost of transportation, customs duties, and other expenses incident to the exchange. The final conclusion to which we are led will be most clearly seen by taking the prices in some one country as a standard of comparison. Let us then consider a unit of any commodity produced in the United States to mean one dollar's worth, as determined by the wholesale price in New York. Suppose, to fix the ideas, that in Liverpool these unit quantities of different commodities have the values shown in the following table. The numbers in the table are supposed to be the quotient of the price in Liverpool divided by the price in New York.

Cotton $1.25
Wheat 1.20
Leather 1.15
Petroleum 1.10
Beef 1.00
Cloth 0.95
Linen 0.90
Iron 0.85
Silk 0.80
Tin 0.80
Wool 0.75

Suppose that in this state of things transportation cost nothing and trade were free. Then it is evident that cotton, wheat, leather, and petroleum would be exported from New York to Liverpool, while cloth and all the articles below it on the list would be imported. If. the values of these exports balanced that of the imports, trade would continue on this basis, though prices might be brought more nearly to a level. But suppose that our exported articles exceeded in value those imported. The result would be an influx of coin to pay for them, and a consequent rise of prices in this country. There would then be less cotton, less wheat, less leather, etc., in a dollar's worth, so that the home prices of these articles would be brought more nearly to an equality with those abroad. The result would be a diminution in the exports of those articles, and an increased importation of articles which it did not before pay to import. The equilibrium would be reached when a sufficient supply of articles imported from the bottom of the list was taken to balance those exported from the top of the list.

Suppose, secondly, that we consider the cost of transportation. This will depend, not upon the value of the product, but upon its weight and bulk. It will prevent trade in those Commodities the prices of which in the two countries do not differ by enough to pay the cost of transportation.

Let us suppose, next, that an import duty of 50 per cent ad valorem upon all foreign products is levied by each country. If the above scale of prices continued to hold, all trade would be stopped by this duty.

Suppose, however, that the duty was levied only by one country, say America. If the scale of prices were unchanged, there *could be no imports to pay for the exports, because the duty would raise the price of all foreign products, even that of wool, above the home price. Since, however, our cotton, wheat, and other commodities are, by hypothesis, admitted free in Liverpool, the exports of those commodities would continue, and would for the time be paid for in gold. The result of this influx of gold would be a general rise of prices in this country. Let us now trace the effects of this rise.

When it reached 10 per cent the export of petroleum would cease; at 15 per cent, that of leather; at 20 per cent, that of wheat; at 25 per cent, should it reach that limit, that of cot-ton. For we can export nothing unless the foreign exceeds the home price, and each of these percentages is the excess of the foreign price before the inflow of gold began.

To see whether this prohibitory limit would be reached, let us consider the articles at the bottom of the scale. The foreign price of iron being 85 cents, the duty of 50 per cent would raise its cost to us, when imported, to $1.27.We should therefore import none, even after the rise in prices. The price of foreign silk, with duty added, would be $1.20. Hence, when the home scale of prices rose to more than 20 per cent, we should begin to import silk, tin, and wool, but should ex-port nothing but cotton. The reduced annual imports and exports would then balance each other at a rise of between 20 and 25 per cent in the scale of prices.

Studying the preceding case, we see that the reason trade' would continue is that the foreign relative price of the three articles at the bottom of the list increased by 50 per cent, the amount of the duty, is still less than the relative foreign price of cotton at the top of the list. Had the duty been 60 per cent, nothing but wool could have been imported, and 70 per cent would have stopped all trade. Our conclusions are :

I. The first and immediate effect of a newly levied ad valorem import duty is to raise the scale of prices in the country which levies it.

II. The ultimate effect, after equilibrium is reached, is to stop all foreign trade except in those commodities whose relative cost of production in the two countries differs by a greater percentage than that of the duty.

III. The import duty cannot permanently impair the equality of values imported and exported, and must there-fore diminish the one as much as the other.

The question may arise whether by increasing the duty on the articles at the bottom of the list a state of things could not be brought about in which the home supply would all be made in this country and nothing would be imported. To answer this question, let us suppose the attempt successful. We should then have a continual export of wheat, cotton, and other commodities which would have to be paid for. If the duties are so high that the exports are not paid for in goods, they would have to be paid for in money. Thus would arise a continual increase in the volume of the currency, accompanied by an increase in the price. This increase could never stop until the influx of gold was stopped by our exports being paid for in goods.

It must be remembered that this increase of price would not be confined to imported articles, but would affect the wheat and cotton exported. When the price of these articles became as high as they were abroad, then their export would necessarily cease, and thus we should have an end of all trade. We there-fore reach the conclusion,

By no device of levying duties can we permanently prevent the imports and exports from balancing each other.

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