One of Tyler Cowen’s commenters asks:

Here is an unrelated topic, but part of the general topic of tax incidence. Do federal employees pay income tax on their wages? I know they do nominally, but that tax goes back to their employer, the federal government. So, doesn’t that mean that, while their actual salary may be lower than their official nominal salary, they actually don’t pay any tax? (NB: this is quite different from a private sector employee whose after-tax salary is less than the pre-tax salary. In that case, the difference between the two does *not* go to the employer, creating a gap between what the employer pays and what the employee receives.)

For example, suppose a private firm and the federal government both value a worker’s output at $100k/yr and the tax rate is 20%. The private firm offers the worker $100k and the worker receives $80k after paying taxes. The federal government, however, can offer the worker $125k in nominal salary, *knowing that it will receive $25k back in income tax*. The net result is that the federal government pays $100k and the worker receives $100k after taxes, i.e., the worker earns $100k tax free, $20k more than he or she would earn at the private firm. Another way of seeing this is to note that taxes paid by employees are economically equivalent to taxes paid by employers. So, if employers received rebates for income taxes paid by employees, then the net income tax would be zero. Well, the federal government *does* receive a rebate for all income taxes paid by employees!

Doesn’t this mean that taxes are doubly distortive? Not only do they discourage employment by creating a gap between what (private) employers pay and what workers receive — the usual cited distortion — they also distort the *composition* of the workforce by allowing the federal government to crowd out other employers.

Tyler says that while this seems wacky, he can’t refute it. I say, it’s clever, but ultimately wrong.


The commenter implicitly assumes that the government—like a competitive firm—will hire up until the nominal wage equals the last worker’s marginal product. However, in the federal government’s case, the marginal product of the worker includes the fact that she pays taxes back to the government. Thus the government effectively has an artificially inflated demand for workers.

This logic break downs, however, because the benefits of the worker’s income tax accrue to the entire federal budget generally of which she is just a small part. So small, that the source of her demand curve—her department and its legislative constituency—is likely unaffected by her contribution to the Federal Budget. Like all taxpayers, she is just as likely to fund a tax cut or an expansion of health care than she is to be funding her own salary.

This implies no alteration in the demand curve and hence no change in tax incidence.