- - - - - - - ~ - - ... - .._ . - ~ -- - -

The Effect of Excises on the Taxation and 

Measurement of Income 

George S. Tolley 

C. Eugene Steuerle 

Comment 

Gerard M. Brannon 
----- ---- --- - - -- - - -,.__- -- --- --

The Effect of Excises on the Taxation and 

Measurement of Income 

George S. Tolley 

C. Eugene Steuerle 

Excise taxes have been a declining part of the Federal tax 

structure for many years. In the last few decades the levying of 

excise has increasingly been left to State and local governments. 

Recent developments have reversed the declining interest in excises at the Federal level. Current energy tax proposals would substantially increase U.S. Treasury revenues from excises. As a concurrent development, concern with tax reform has led to a reconsideration of whether State and local excise taxes should continue 

to be allowed as deductions on individual Federal income tax 

returns. 

This paper considers three controversial questions that take on 

importance when excises are placed in an economy that both 

measures and taxes income. First, if Federal excises are increased, 

will income tax collections be affected? Any significant effect needs 

to be taken into account in revenue estimation and macroeconomic 

policy decisions. Specifically, will the levying of a Federal excise 

tax reduce Treasury income tax revenues, and, if so, by how much? 

A second question concerns the measurement of national income. Since excise taxes are subtracted from national product 

when determining national income, it is possible that switches in 

GEORGE S. TOLLEY is with the Department of Economics at the University of Chicago, and C. EUGENE STEUERLE is with the Department of 

the Treasury. 

(67) 
68 COMPENDIUM OF TAX RESEARCH 

the form of taxation-for instance, raising more revenue from 

excise taxes and less from income taxes-will arbitrarily affect 

measured national income. More generally, there is the possibility 

that a change in excises could change measured national income 

even though there was no real change in employment or output of 

the economy. The question becomes: Will a change in excises lead 

to totally arbitrary changes in the measurement of national income, and, if so, what remedy is called for? 

A third perennial question is how to treat State and local excises 

for purposes of Federal taxation. Involved here is the broad issue 

of how to mesh tax systems at different government levels. Do 

principles of neutrality and horizontal equity suggest criteria for 

deductibility of State and local taxes, and what do the criteria 

indicate about the treatment of excises? 

A key idea governing the answers given in this paper to these 

three questions is that an excise tax, in contrast with a personal 

income tax, is a cost of doing business. It is recognized as such by 

business firms and by Federal, State, and local taxing authorities 

in the calculation of business income and the paying out to recipients of income left after expenses. Because the analysis in each 

case is governed by this key idea, the answers given in this paper 

to the three questions are at once definite and surprisingly simple. 

Effect of Excise Taxes on Income Tax Collections 

When a new excise of $10 is levied, the $10 is paid to the government, and $10 less income is left in the private sector. The $10 

will be subtracted as a business expense, and there will be $10 less 

available to pay out as wages, salaries, interest, and dividends or 

to keep as retained earnings. Since the tax reduces the amount of 

payments to factors of production, it reduces the amount of their 

income that can be subject to tax. Hence, the first of the three 

questions can be answered: An increase in excise taxes will reduce real income tax collections. 

Real and Nominal Changes 

Even though the logic leading to the proposition is simple, it has 

been argued that the burden of an excise may be passed forward 

to consumers with no change in factor payments and, hence, no 

change in income tax collections. The most straightforward version of this line of thinking is that factor prices are rigid down-
THE EFFECT OF EXCISES ON TAXATION 69 

ward, and that the excises must therefore be passed along as cost 

increases and result in a general increase in product prices. If this 

is the case, factor payments and, hence, income subject to tax will 

not change-with the result that the introduction of the excise 

leaves income tax payments unaffected. 

The argument in this form disguises the issue of the measurement of real vs. nominal changes in income. In real income terms, 

the original proposition remains valid. If rigidities do prevent 

money incomes from falling, then product prices must rise, and 

the purchasing power of income-as measured by money payments 

divided by power prices-must fall. That is, the purchasing power 

of an hour of labor or capital services will decrease because of the 

excise, regardless of the ultimate inflationary effect of the excise. 

Similarly, even if income tax payments are unaffected in money 

terms, real income tax payments will fall. 

A question remains as to whether the amount of the fall in real 

income tax payments is affected by a possible inflationary impact 

of excises. If income tax liabilities were perfectly indexed, any inflationary impact would be reflected in an equal proportionate 

change in money tax payments. That is, tax collections would 

equal a constant proportion both of income subject to tax and of 

factor payments. Since the real value of these factor payments 

would fall by the amount of the excise tax, the fall in real income 

tax payments would be the same no matter what the general price 

level effects. In the present, nonindexed, progre.ssive income tax 

system, however, any inflationary impact changes money tax payments and factor incomes at different rates. In the extreme case, 

one in which there is no fall in money incomes, the entire reduction in real values of the income tax comes from price rises. This 

contrasts with the case in which there is no price change and the 

entire fall in real income tax collections is the result of reduced 

money tax liability. 

Let nominal income tax collections T depend on factor incomes 

F: 

T=T (F), (1) 

where progressivity implies that the marginal tax rate T' (F) is 

greater than the average rate TI F. The value of final output Y 

differs from factor incomes by the value of excise collections V; 

i.e., 

F=Y-V. (2) 
70 COMPENDIUM OF TAX RESEARCH 

With an ad valorem excise tax rate v on sales of final output, excise 

collections are v percent of the value of final output, or 

V =vY. (3) 

Combining equations (2) and (3) implies that F= (1-v) Y or 

y 

that the output/factor ratio, -, equals 1/1-v. The value of final 

F 

output can in turn be expressed as a price level index P times real 

output y: 

Y=Py. (4) 

Factor income then equals the percent of final output remaining 

after excises times the price level for final output times real output: F= (1-v)Py. Substituting this result into equation (1) gives 

for tax collections : 

T = T [ ( 1 - v) Py] . (5) 

To find the effects of an increase in the excise tax rate v on income tax collections T, take the differential of equation (5) and 

divide the result by equation (5) to obtain changes in percentage 

terms. Using the substitution F= (1-v)Py then gives: 

dT I T= [T' I (T IF)] [ (dP /P) -dv/ (1-v)]. (6) 

Equation ( 6) says that the percentage change in nominal income 

tax collections equals the elasticity of revenues with respect to 

nominal income T' I (TI F) multiplied by the difference between 

the percentage change in prices, dP/P, less the change in the excise tax rate, dv, times the value of output remaining after payment of excises, 1/ (1-v). 

To find the effect on tax collection requires knowledge of the 

price level change, dP IP. It is not clear that prices will change in 

response to an increase in excises ; i.e., -dP I P may be zero. On the 

other hand, if fact.or prices are determined exogenously, excises 

would be passed forward entirely by inflationary price increases, 

and every one percent rise in excises as a fraction of value remaining after excises would result in a one percent rise in the 

price level. 1 To consider alternative cases, the parameter h may 

1 Let n be the number of factor units in the economy, and let the money 

payment per unit of factor be W, which implies factor payments are F= Wn. 

Let c be the output produced by each factor unit, so that real output i's 

given by y=cn. Using equation (4), the amount remaining for factor payments after excise tax collections is F= (1-v)Pcn. Equating the expressions 

for F in the two preceding expressions and rearranging as an expression 

for the deflated or real value of factor payment per unit gives 

WIP=c(l-v). 
THE EFFECT OF EXCISES ON TAXATION 71 

be introduced: 

dP/P=h dv/ (1-v), (7) 

where his the percentage rise in prices resulting from a one percent rise in excises as a fraction of value remaining after excise.s. 

The value of h equals zero if there is no inflation and one if excises 

are entirely passed through as price increases, while it may take 

on intermediate values between one and zero. 

dP Substituting the expression for p from equation (7) into 

equation ( 6) and rearranging as an expression for the percentage 

decreasP in nominal tax collections resulting from a one percent 

increase in the excise rate gives 

dT (1-v) - dv. T - (l-h).,,, (8) 

where 71 is the elasticity of nominal taxes with respect to nominal 

income T'(F)/(T/F). With no inflation (h=O)., nominal income 

tax collections go down by the full value of the elasticity 71• With 

maximum inflationary impact ( h = 1), nominal income tax collections do not change. 

Now consider the real value of income tax collections t. Since 

t= T / P, the percentage change in real income tax collections obeys 

dt/t=dT/T-dP/P. (9) 

Combining equations (7), (6), and (9) results in the following 

expression for the percentage decrease in real income tax collections resulting from a one percent increase in the excise rate: 

dt 1-v --·--= (1-h).,,+h. dv t (10) 

The decrease in real income tax collections is an average of the 

noninflationary elasticity of income tax collections, 71 , weighted by 

the excise fraction, 1-h, not passed on in inflationary price increase plus the inflationary elasticity of unity times the fraction h 

that is passed on in inflationary price increases. The Inflationary 

elasticity, implied by coefficient of h, is unity because with no 

Taking percentage changes: 

dW /W-dP/ P=-dv/ {1-v). 

This result shows that if there is no inflation (dP/P=O), factor payments 

per unit will fall by the same percentage as the rise in excises as a fraction 

of value remainin~ after excises. If factor payments are completely rigid 

downward ( dW I W =0), the price level will rise by the same percentage as 

the rise in excises as a fraction of value r€maining after payment of excises. 

These cases represent bounds to the analysis. 
72 COMPENDIUM OF TAX RESEARCH 

change in nominal factor payments and hence no change in income 

tax collections, real income tax collections will change simply in 

proportion to the price level. 

As a numerical illustration, if the marginal rate of tax on nominal income T' (F) is .25 (which is itself an average of all the individual marginal rates in the economy when total income changes) 

and if the average rate of taxation T / F is .10, then the elasticity 

.,, is 2.5. From equation (8), nominal income tax collections will fall 

2.5 percent for each one percent increase in the excise fraction if 

there is no inflationary impact (h=O). Nominal income tax collections will not fall at all if there is complete pass-through (h= 1) ; 

in an intermediate case, collections will fall 1.25 percent if the 

elasticity of prices with respect to the excise fraction is one-half 

(h= .5). 

From equation ( 10), real income tax collections will fall 2.5 

percent if there is no inflationary impact (h=O), 1 percent if there 

is complete pass-through (h= 1), and 1.75 percent if the elasticity 

of prices with respect to the excise fraction is one-half (h= .5). 

Thus, while the proposition that real income tax collections will 

fall is not in doubt, the magnitude of the decline varies under a 

nonindexed progressive income tax system. To estimate the magnitude of real tax collections .requires knowledge of the extent (if 

any) to which absolute prices will rise as a result of an excise. It 

is also clear that the change in nominal income tax collections-if 

these are of interest-will depend on the extent to which prices 

rise. 

Excises and the Causes of Inflation 

Because the change in real income tax collections will be influenced by the extent to which an excise raises the price level, it 

is necessary to consider the issue: To what extent, if any, does an 

excise cause inflation? To estimate the impact of a change in 

excise taxes, an explicit estimate of inflation needs to be made, and 

it should be carried through the entire analysis, with impacts on 

the economy presented in real as well as nominal terms. 

The following discussion indicates some of the considerations 

that go beyond traditional tax considerations. Views on the extent 

of inflation induced by excises vary widely. However, it is often 

assumed that excises result dollar for dollar in higher product 

prices and that there is no effect on money payments to factors of 

production. Analyses of the value-added tax have featured this 

assumption, as have some analyses of energy tax proposals. The 
THE EFFECT OF EXCISES ON TAXATION 73 

rationale for this assumption has apparently been the ratchet hypothesis-that money wages can go up but not down. While more 

recent views retain the idea that wages change less rapidly than 

prices, these views also stress that wages have greater flexibility 

over a longer period and that wages do respond to events in the 

economy. For instance, wages could be set in anticipation of prices 

so that the expected level of wages divided by prices, or real wages, 

would reflect. expected labor market conditions. Since the economy 

is made up of many different labor markets, some wages are 

changed quite frequently while others are not. Some wages will be 

set through labor negotiations and some through freer competitive 

adjustments. Some wage payments will respond quickly to a 

change in demand and supply conditions and others will not. 

Therefore, in an economy experiencing continuing inflation, a 

downward shift in labor demand may result not in an absolute 

decline in money wages, ... but in less of a rise than would otherwise have occurred. 

In such a system of wage determination, consider the introduction of a universal ad valorem excise on all final goods. Given the 

absence of instantaneous adjustment of wages, cost curves of 

firms will be raised. A reduction in output will be avoided only if 

monetary and fiscal authorities somehow offset the possible decrease in aggregate supply. 

First, suppose that these authorities are unsuccessful in fully 

offsetting the decrease. This appears to be the most likely outcome 

because of the uncertain atmosphere in which monetary and fiscal 

policy decisions take place and because of lags in effects of these 

policies. For instance, the introduction of the excise-one of the 

myriad events of unknown impact affecting the course of the 

economy at any time-may, by inducing firms to reduce output, 

lead to a reduction in the demand for money and credit. If the 

Federal Reserve is maintaining interest rates and credit availability at predetermined levels, a contraction of money and credit 

will automatically occur in response to the reduced demand. To 

counter the automatic contraction successfully, the Federal Reserve must actively undertake changes to make credit easier. The 

information on which to base such a decision may well not be 

available, and even if it is, an atmosphere of uncertainty may discourage action. If the excise perturbation is minor relative to 

other changes occurring, the likelihood is increased that there 

will be no monetary reaction to the excise. If to these considerations is added the uncertainty about the lag in monetary policy, 

several months may elapse before considerations are effective. 
74 COMPENDIUM OF TAX RESEARCH 

Similarly, on the fiscal side there may be lags and uncertainties 

in the development of policy. For instance, the agencies of the 

Government may not be able to bring about an immediate increase 

in demand through an increase in purchases. 

In the likely event, then, that the effect of the excise tax is not 

fully offset, the excise would likely have an effect in factor markets. Wage contracts just being renegotiated may respond to the 

more slack conditions by anticipating a somewhat lower real 

wage. In this manner, a part of the impact of the excise tax may 

be reflected back in a lower money wage than would otherwise 

have prevailed-correspondingly reducing inflationary impact on 

product prices. 

On the other hand, even if the Government is successful in fully 

off setting the effect of the excise tax, dollar for dollar inflationary 

impact still may not occur. For example, suppose that the Government returns the excise in the form of reduced direct taxes on 

factor payments. Then, while real before-tax factor payments 

would go down because of the excise, real after-tax income would 

rise because of lower direct taxes. If owners of factors are myopic 

and price their factors only by nominal before-tax wages and 

profits, then the inflationary impact is much different than if they 

price the factors according to the net after-tax payments. In the 

latter case, if the excise tax is inflationary, then the lower income 

tax is deflationary. Again, even if there is some immediate or 

short-run inflexibility in nominal before-tax wage and profit rates, 

it may be reflected more in shifts in rates of increase of various 

factor payments than in an increase in the aggregate rate of increase of product prices. 

The discussion thus far has concerned a universal excise. For 

the more usual case of an excise tax applied to only one commodity 

(e.g., oil or gas) rather than to all commodities, there will be relative price effects as firms producing the commodity encounter 

higher costs when the excise is introduced. The same considerations suggesting either an imperfect monetary or fiscal response 

or, in the case of a perfect response, an offsetting deflationary 

pressure, apply a fortiori to a price rise originating in only one 

part of the economy. Meanwhile, with or without these responses, 

shifts in output composition and deployment of factors will begin, 

and these shifts will affect both the price and unemployment impacts of the excise. While output and employment in the taxed industry will grow more slowly than they would have otherwise, 

the reduction in that industry relative to all other industries may 

be accomplished in part, and perhaps in whole, by a slowdown in 
THE EFFECT OF EXCISES ON TAXATION 75 

its rate of increase in the hiring or replacement of labor. The result will then be a greater rise in the price of the taxed commodity and a lesser rise in the price of other commodities than would 

have occurred in the absence of the excise--with the path of the 

general level of prices being affected little or possibly not at all by 

the excise. 

Distributional Effects of a Single Commodity Excise 

To analyze the distributional effects of an excise, the formulas 

for estimating real and nominal effects of a universal excise proposed in the first section of this paper are often inadequate. A 

more general framework is needed to handle the effects of an excise on a single commodity. A single-commodity excise generally 

leads to a change in the price of the taxed commodity relative to 

all other commodities as well as to reductions in real factor income remaining after collection of the excise tax revenues. As 

before, the reduction in real factor payments will reduce real income tax collections. 

The more general framework is particularly relevant when there 

is the possibility of designing an additional tax package that will 

off set the distributional effects of the tax. A naive approach is to 

calculate the effect of the excise on expenditures of each income 

group according to the amount of the commodity each currently 

purchases and to assume that this constitutes the impact on the 

income group. Column (a) of table 1 demonstrates such an effect 

for a $32 billion excise on a single commodity of hypothetical 

interest. 

This first column gives only the loss to each income group from 

the rise in price of the taxed commodity. This increase in relative 

price of the taxed commodity has as a counterpart a fall in the 

relative price of all other commodities. The gain is calculated in 

column (b). The fall in the relative price of all other goods necessary to keep the general price level constant is calculated, and this 

is multiplied by the expenditures on all other goods by each income group. Because of differences in expenditure patterns for the 

taxed and untaxed commodities, the gains from the lower relative 

prices of untaxed commodities do not exactly offset the losses on 

the taxed commodity for any individual income group-although 

the off set is exact summing over all income groups. Column ( c) 

shows the net effect of the price changes for the taxed and untaxed 

commodities. In this case the taxed commodity is consumed relatively heavily by lower income groups, so that the net effect is a 
-::J 

~ 

TABLE 1.-Effects of an E x c·ise Tax on a Single Commodity 1 

(a) (b) (e) 

Losses due Gains from (c) Income tax (f) 

to change in decline in Net effect (d) changes due Total effect 

price of relative of price Factor to change of tax 0 

taxed price of changes income in factor (c)+(d) 0 

commodity other goods (a)+(b) change incomes +(e) a:: 

'"ti 

t:rj 

Persons who pay no income -2.94 2.19 -.75 -3.01 0 -3.76 z 

t:::l 

tax 

1-4 

c:: 

Income taxpayers by adjusted a:: 

gross income class 

0 

$ 0-2,999 -.24 .17 -.07 -.26 .06 -.27 ~ 

3,000-4,999 -1.26 .99 -.27 -1.13 .32 -1.08 1-3 

> 

5,000-6,999 -2.07 1.63 -.44 -1.60 .43 -1.61 >< 

7,000-9,999 -3.76 3.26 - .50 -2.83 .76 -2.57 ~ 

t:rj 

10,000-14,999 -7.07 6.72 -.35 -5.24 1.48 -4.11 rn 

t:rj 

15,000-19,999 -5.49 5.90 .41 -3.92 1.20 -2.31 > 

~ 

20,000-49,999 -7.16 8.50 1.34 -6.95 3.02 -2.59 0 

50,000-99,999 -1.21 1.56 .35 -2.94 1.65 -.94 tI:: 

100,000 or more -.74 1.03 .29 -4.06 2.43 -1.34 

Total - 31.94 31.94 0 -31.94 11.35 -20.59 

1 In $ billions. 
THE EFFECT OF EXCISES ON TAXATION 77 

loss for lower income groups and a gain for higher income groups. 

Because of the excise tax, there is a $32 billion reduction in real 

factor income left in the private sector. Column (d) distributes 

this loss in income among the income groups. Here the loss is distributed proportionately to factor earnings in each income group. 

This procedure seems reasonable, but more sophisticated estimates could be used if available. Column (e) applies the marginal 

income tax rate for each group to the income change to show the 

reductions in income tax payments. Column (f) then sums the 

effect of the price, income, and income tax changes to obtain the 

total effect on each income group of imposing the single-commodity excise tax. Comparing the first and last columns of the table 

reveals the substantial difference between using the naive approach and the more general framework suggested here. 

Table 1 has been calculated assuming no inflationary impact of 

the excise. This is a reasonable procedure for the purpose at hand. 

If an estimate of inflation is t6 be used, the ll_Umbers in columns 

(d), (e), and (f) would need to be calculated in both nominal and 

real terms. The income tax changes would be estimated in both 

real and nominal terms according to the same types of formulas 

given earlier for a universal excise. The necessity of presenting 

two sets of estimates-one nominal and the other real-would 

serve the purpose of calling attention to built-in assumptions about 

inflation and to the real as well as monetary effects on taxpayers. 

The Measurement of National Income 

The second question posed at the outset was whether an increase 

in excises would affect the measurement of national in~ome. Simplifying national income accounting somewhat, national income 

can be calculated from the product side of the accounts. Starting 

with gross national product (GNP), capital consumption allowances (A) are subtracted to arrive at net national product (P) : 

GNP-A=P. (11) 

National income ( YN) is then obtained by subtracting indirect 

taxes (Ti) from net national product: 

P-T1=YN. (12) 

It can be seen that a substitution of indirect taxes, including 

excises, for direct taxes will affect measured national income without affecting gross national product. That there should be no effect 

of a change in the form of taxation on measured welfare seems 
78 COMPENDIUM OF TAX RESEARCH 

reasonable, but while the condition holds for gross national product, it does not hold for national income. The usefulness of the 

national income concept as a welfare measure is called into 

question. 

National income accurately measures the value of factors of 

production when their value can be measured by what the owners 

of those factors accept as payments for provision of the factors 

before the payment of income tax but af.ter the payment of excise 

t~x. Yet, clearly, if one wishes to value the output of factors at the 

pr,ice received, then that price is net of direct taxes as well as 

indirect taxes. In fact, if there were to be a net factor payments 

(NFP) equation, it would be: 

NFP=YN-Td. (13) 

However, as a measure of income received, the usefulness of a 

net factor payments measure would be inadequate. Equation ( 13) 

properly measures the purchasing power provided to individuals 

through their provision of factors, but not their total purchasing 

power nor all expenditures made in their behalf. The difference 

comes from analyzing what the Government does with the taxes. 

The Government may provide goods and services ( G) or transfers (Tr) to the economy. If the Government maintains a balanced 

budget, then 

Tr+G=T;.+Tn. (14) 

From equation (14), it can be seen that while the value of net 

factor payments may be less by the amount of taxes paid, the income received by citizens in the economy may not be less at all, 2 

since the decrease in real factor payments will be offset by an 

increase in real Government expenditures or real Government 

transfers. 

In the national income accounts, transfers are added back to 

national income to arrive at a definition of personal income, (YP) ; 

i.e., 

YP=YN+Tr. (15) 

Personal income thus comes closer to a measure of income received 

than does national income, but it still has shortcomings. If product 

equals consumption ( C) plus Government expenditure, then rearranging equations (14) and (12) yields: 

2 If the Government does not balance its budget, then the further effect of 

changes in Government debt or money supply complicates the analysis, but 

does not mitigate the point that the income received by citizens need not be 

less because of the presence of an excise tax. 
THE EFFECT OF EXCISES ON TAXATION 79 

YP=C+G+ (Tr-T1). (16) 

Since the relationship of transfers to indirect business taxes is 

not strong, personal income also does not make sense as a measure 

of income received, and its measurement is affected by a switch 

from direct to indirect taxes. 

In short, the conceptual distinction between indirect business 

taxes and direct taxes for purposes of national income accounting 

does not appear useful, particularly since it affects what was supposed to have been the basic measure of economic performance, 

namely national income. A reason the issue is not of more importance is that gross national product has, over the years, supplanted national income as the most frequently used measure. 

To obtain a measure either of performance net of depreciation 

or of welfare, it would seem be-st not to allow a deduction of indirect business taxes. The basic measure of performance would be 

net national product. If a modification in thinking along these lines 

is not made, then changes in excise taxes-whether at the Federal, 

State, or local level-will continue to result in arbitrary and misleading changes in the measurement of the nation's economic 

performance. 

Deductibility of Excises 

The third question with which this paper is concerned has to do 

\Vith the effects of allowing excise tax payments as a deduction in 

filing individual Federal income tax returns. 

When a sales tax is paid and the receipts are turned over to the 

Federal, State, or local taxing authority, the proceeds are not 

available to pay out to labor and capital claimants. Thus, we have 

for private firms: 

Receipts taken in from the sales of final products 

Less : Excise tax proceeds turned over to taxing 

authorities 

Equals: Income available to pay to the factors of production which will be reported as taxable income. 

This statement is roughly equivalent to equation (12) in the 

previous section. 

This accounting procedure for excises contrasts with the procedure for income taxes. The reported income for tax purposes 

paid to the factors of production is gross of any individual income 

taxe-s. Income taxes must be paid out of the reported income re-
80 COMPENDIUM OF TAX RESEARCH 

gardless of the amount withheld from that income for tax purposes. For the Federal Government to arrive at a net factor income available to individuals after all State and local tax expenses 

have been paid requires subtracting the State and local income 

taxes paid from the reported income received by the factors of 

production. Thus, 

Income available to pay to the factors of production, which will be reported as taxable income 

Less: State and local income taxes 

Equals: Net factor income remaining after payment of 

individual expenses, including taxes at the State 

and local levels. 

Again, this statement is roughly equivalent to equation (13). 

Since business firms have already deducted excise taxes from 

income before making income payments to the factors of production, a further individual deduction of such taxes constitutes a 

double deduction of the excise taxes. 

In terms of the simple income accounting system of the previous 

section, the extra deduction of indirect taxes makes the aggregate 

tax base equal factor income less indirect taxes ( YN -Ti) or 

product less indirect taxes twice (P-Ti-Ti). 

The same cannot be said of State and local income taxes. These 

have not been deducted from business receipts before making 

factor payments. If a goal of the tax system is to attain a symmetry with excise taxes, an individual's State and local income 

taxes should be allowed as a deduction against Federal taxable 

income, but excise taxes should not be allowed as a deduction since 

these have already been deducted as an expense at the business 

level. The Federal income tax base then becomes (P-Ti - T n), not 

(P-Ti.-Ti-TD). 

Assume that the Federal Government does not yet allow any 

itemized tax deductions. Then contrast a closed community in 

which $10 is collected in sales tax with one in which $10 is collected in income tax. Suppose that in both jurisdictions all taxes 

are transferred to the citizens through nontaxable transfers and 

further that $100 worth of goods and services are purchased from 

firms by those citizens. In the jurisdiction with the sales tax, purchases of $100 of goods will result in a sales tax of $10, leaving 

$90 in income to be paid out by firms as wages and profits. In the 

jurisdiction with the income tax, purchases of $100 will again 

result in about $90 of after-tax income being collected in wages 

and salaries, as firms withhold $10 in income tax on those wages 
THE EFFECT OF EXCISES ON TAXATION 81 

and profits. In this latter case, however, the before-tax income 

will equal $100-and that is the amount (not the after-tax income) that is reportable for Federal income tax purposes. In the 

jurisdiction with the sales tax, only $90 will be reported as wages 

and profits, as firms deduct the tax payments from total receipts 

in calculating their profits. 

To the extent that there are spillovers from community to 

community, or that products and services purchased in one community are supplied from another community, the benefit of an 

extra deduction would need to be apportioned across communities. 

Still, there is no doubt that in aggregate the sales tax lessens the 

total amount of income subject t.o tax while the income tax does 

not. 

In summary, the current procedure of allowing an individual to 

deduct an estimate of excise tax payments attributable to his purchases constitutes a deduction over and above that already allowed 

through the tallying of business receipts and expenses. For this 

reason, relative to a taxing authority that relies more heavily on 

income taxes, a non-Federal taxing authority that relies more 

heavily on excises to finance a given bundle of services will find its 

citizens favored in terms of lightened Federal income tax loads. 

While the disallowance of the deduction of excise taxes at the 

individual level would achieve neutrality between different forms 

of taxation at the State and local levels, neutrality would still not 

be achieved in the choice between private and public provision of 

goods. If one jurisdiction chooses to provide services such as waste 

disposal through hiring public employees and paying for them out 

of its tax receipts, the taxes used to finance the services are deductible as an expense. The citizens of that jurisdiction will then 

have reduced Federal income tax liabilities. If the jurisdiction discontinues public provision and leaves the providing of services t.o 

private firms, it can reduce the taxes that were formerly necessary 

to pay for the services. Individuals will then have more income 

from the tax reduction t.o purchase the services privately. However, the expense of the purchases will not be deductible by individuals on Federal income tax returns because the services are 

not purchased through taxes. The deduction of State and local 

taxes thus gives an incentive to provide services publicly rather 

than privately. 

One means of eliminating this bias would be t.o disallow the 

deduction of State and local income taxes on individual Federal 

returns and to disallow the excise tax deduction on both individual 
""" - - - - - -- - ~~ 

82 COMPENDIUM OF TAX RESEARCH 

and business returns. A proposal of this kind may not be practical 

and is unlikely to be considered seriously at this time. 

An alternative means of eliminating the bias would be to add 

back to income the governmental expenditures or transfers that 

are financed through the tax collections. Theoretically, this is the 

preferred alternative, since the individual payer of the taxes is not 

necessarily the beneficiary. 

Much confusion over the appropriate tax base for income taxation results from the failure to define specifically what is meant 

by "income" or the base that is to· be taxed. Implicitly, any of the 

income bases mentioned in the previous section could be used : 

product, factor payments gross of direct taxes, factor payments 

net of direct taxes, or personal income. None of these four would 

allow for the extra deduction of the indirect taxes. 

However, it was also argued in the previous section that product 

is a measure that does not vary when taxes are converted to governmental expenditures and transfers and does not vary when 

direct taxes are substituted for indirect taxes. Suppose now that 

an "income" tax base that was analogous at an individual level to 

"product" on an aggregate level were to be designed. In addition, 

suppose it was necessary to rely on factor payments as the starting 

point for calculating the base. Some further rearranging of the 

equations of the previous section reveals that 

P=YN+G+Tr-Td. (17) 

The value of this type of measure of income can be deduced 

from the argument often made that the value o.f transfers and 

governmental services ideally should be included in income. This 

implies that the income base to be taxed comes closer to a measure 

of product than of factor payments. 

Equation (17) also shows the logic of allowing a deduction of 

direct taxes from the income tax base and treating separately the 

question of how or whether governmental expenditures and transfers might be counted in taxable income. State and local provision 

of goods is still favored to the extent that it is not counted in 

individuals' incomes, but this is justifiable-at least in some cases 

-by the administrative impossibility of measuring the amount of 

services received by each individual. In any case, the equation 

clearly demonstrates that it is not necessary to allow a deduction 

of indirect taxes in order to obtain a measure of the income of the 

individual. 

In conclusion, to achieve neutrality among taxes, either excises 

as well as State and local income taxes should be allowed once and 
THE EFFECT OF EXCISES ON TAXATION 83 

only once as a deduction from the income stream, or none of the 

taxes should be allowed as a deduction. The once-and-only-once 

approach-which would be achieved by disallowing an individual 

excise tax deduction-appears the more practical. Either approach 

is superior in terms of neutrality to the present asymmetric treatment of the taxes. 

Conclusion 

This paper has attempted to develop a unified approach to the 

analysis of excises as they relate to a Federal system which both 

measures and taxes income. In addition to helping answer the 

three specific questions considered here, this framework should be 

useful as future issues related to excises arise. 
84 COMPENDIUM OF TAX RESEARCH 

COMMENT 

Gerard M. Brannon, Georgetown University 

In the public finance literature there is an uneasy truce over the 

argument that an excise tax must be passed backward into lower 

factor prices, an argument that goes back to Harry G. Brown 

(1939) and Earl Rolph (1952). Assuming that both Mand V are 

unchanged by the tax, there could be no general increase in average prices but the average price must increase if excise taxes are 

to be shifted forward. With the market value of GNP fixed, factor 

incomes must fall by the amount of the excise-tax increase. 

Many economists have held that under most circumstances it is 

proper to assume that the monetary authorities expect the tax to 

be shifted forward and therefore to provide the necessary increase 

in M. This can lead to a considerable methodological debate about 

the appropriate assumptions for tax shifting analysis (Buchanan, 

1960). 

Tolley and Steuerle chew over this old bone in the context of 

several specific tax analysis issues in which the question of excisetax shifting lurks in the background. 

The first specific deals with several matters of revenue forecasting. To start with, the authors make the point that even if one assumes forward shifting, the real value of income tax collections 

is reduced. I do not know if any of the "forward shifters" have 

made this point, but I cannot imagine anyone disagreeing with it. 

Another technical point about revenue estimating made by the 

authors is that if there is no price increase, real income tax colleotions fall by the marginal income tax rate times the excise-tax 

increase. With full forward shifting, real income tax collections 

fall only by the average tax rate times the excise tax increase. The 

difference in the two cases is that forward shifting amounts to 

general inflation, and income taxes rise due to inflation. 

After these formalities the authors finally get around to the substantive issue: What assumption should revenue estimators make 

about forward shifting (i.e., about whether inflation will be allowed to accommodate forward shifting) ? Clearly Tolley and 

Steuerle are right that asserting downward inflexibility of money 

wages does not settle the matter because backward shifting could 

be accomplished by reducing increases in money wages. After some 
THE EFFECT OF EXCISES ON TAXATION 85 

vague argumentation, well sprinkled with "may's" and "likely's," 

they conclude in favor of backward shifting, especially for a nongeneral excise tax, such as one on oil and gas. 

~ do .JlOt find the argument very convincing. Their "strong" 

point seems to be an assertion that the monetary authorities, not 

knowing precisely how much to ease credit to provide full accommodations, will ease credit by a lesser amount. Why a lesser 

amount is not clear. 

As applied to the potential issue of an energy tax, that tax 

must be viewed as a substitute for adapting U.S. energy prices 

to the current price of imported oil. !fhere is some serious literature (Gordon, 1975; Phelps, 1977) on the consequences o.f alternative monetary accommodation policies with regard to energy 

Prices that seem appropriate to an energy tax. The practical advice to Treasury revenue estimators is to make every effort to 

obtain the appropriate price ,assumption from the Council of 

Economic Advisors or from the Federal Reserve. Having decided 

on the assumption, the authors' argument is correct that the 

aggregate implications of any assumed inflation should be taken 

into account. 

The last revenue estimating point Tolley and Steuerle deal with 

is back in the noncontroversial area: the burden distribution of 

an excise-tax increase by income classes looks rather different in 

the backward- and forward-shifting cases. In an illustrative calculation it is shown that the total effect of a backward-shifted 

energy tax is more regressive than that of a forward-shifted one 

since the lower factor incomes in high-income brackets are modified by lower income taxes. (The data sources for the table are 

not given and some entries look suspicious; persons who pay no 

income taxes have a higher share of factor incomes -than they 

have of consumption expenditures!) 

The next specific analytic issue the authors address is the usefulness of the statistical series "national income." There can be 

little disagreement with the conclusion that national income, which 

subtracts excise taxes, but not income taxes, from GNP is quite 

useless. 

The third specific analytic issue is the deductibility of State and 

local general sales taxes for purposes of the Federal income tax. 

On the basis of their preference for assuming backward shifting, 

Tolley and Steuerle conclude that sales taxes have already been 

excluded from factor incomes and that a specific deduction for 

estimated taxes "paid" is improper. Since factor incomes are reported before State and local income taxes, the deduction of income taxes is acceptable. 
86 COMPENDIUM OF TAX RESEARCH 

A number of arguments about the deductibility of State and 

local taxes can be raised. I limit myself here to addressing the 

specific point argued by Tolley and Steuerle that present law 

allows a "double" deduction and exclusion of sales taxes. Some 

simple examples of pairs of States with equal real incomes will 

throw some doubt on the conclusion. 

The pair of States A and B have no interstate trade, so price 

levels are completely independent. Therefore, I assume backward 

shifting of B's sales tax. A has no sales tax but raises equal revenue by income tax. 

The pair of States C and D obtain goods from the same suppliers, so prices before tax are the same. D has a sales tax and C, 

an equal income tax. It follows that market prices in D will be 

higher by the amount of the Sales tax. We also consider the pair 

of States C' and D', which are like C and D except that they are 

under a stern monetary authority that insists on backward shifting of the average sales tax. The state-aggregate economic accounts are as follows : 

A B c D C' D' 

Net national product 100 100 100 110 95 105 

State sales tax 0 10 0 10 0 10 

"National" income 100 90 100 100 95 95 

State income tax 10 0 10 0 10 0 

Taxable income without 

sales tax deduction 90 90 90 100 85 95 

Taxable income 

with sales tax deduction 90 80 90 90 85 85 

The case the authors describe is pair AB. Under these circumstances, factor income in B is already reduced by a backwardshifted sales tax; allowing a Federal tax deduction for State sales 

taxes in this pair would produce a lower tax in B even though 

taxpayers in A and B have the same real income. 

In the CD case, articles in D sell at the same manufacturers' 

list price as in C but the local sales tax is added to the price. Here 

deduction of the sales tax is called for to produce the same Federal taxable income for taxpayers with the same real income. The 

CD case is not changed in substance if we assume that when D 

imposed its sales tax there was no increase in average prices and 

thus a fall in prices before tax and in factor incomes (C'D'). 

I conclude that the problem Tolley and Steuerle set for themselves cannot be solved by this general theorizing about forward 
THE EFFECT OF EXCISES ON TAXATION 87 

or backward shifting. What is involved is an empirical question 

about differences in total prices of taxed g6ods between sales-tax 

and no-sales-tax States (or between high- and low-rate-sales-tax 

States). Without having done this rese;;trch I suggest that the conventional wisdom is that, ceteris paribus, prices differ by the sales 

tax. 

References 

Brown, Harry G. "The Incidence of a General Output or a General Sales 

Tax." Journal of Political Economy 47: (1939), pp. 254-262. 

Buchanan, James. "The Methodology of Incidence Theory." Fiscal 

Theory and Political Economy. Chapel Hill: University of North 

Carolina Press, 1960. 

Gordon, Robert. "Alternate Responses of Policy to External Supply 

'Shock." Brookings Papers on Economic Activity 1: (1975), pp. 183-

206. 

Phelps, Edmund. "Commodity-Supply Shock and Full Employment Monetary Policy" (Discussion Paper 77-7806). New York: Columbia University, Department of Economics, October 1977. 

Rolph, Earl. "A Proposed Revision of Excise-Tax Theory." Journal of 

Political Economy. 60: (1952), pp. 102-117.