In economics, tax incidence is a term used to describe how taxes are distributed between buyers and sellers. The tax burden can fall more on individuals or organizations depending on the unique circumstances around the product. The difference between initial tax incidence and the final burden is called tax shifting.
Tax incidence is a measure of whom the true weight of taxes falls upon. It involves analyzing new tax policies and their effects on consumers or producers due to price changes. For example, policies that increase the price elasticity of supply compared to demand can raise the weight of the tax burden on consumers.
Tax incidence is the extent to which taxes are distributed between the buyers and sellers in a market.
The tax incidence depends upon the price elasticity of supply and demand.
When a good is considered inelastic, in many cases, suppliers can pass the tax burden to the consumer as they are still willing to purchase the product.
Tax Incidence Explained
Tax incidence economics is typically studied using supply and demand analysis. French Physiocrats like François Quesnay first introduced the idea in the context of the tax burden on landowners.
Taxes are a necessary evil. Nobody likes to pay them, but the government has to impose them for raising revenues and paying down debt.
However, the introduction of new tax policies always lays the exertion on someone. In most instances, it falls on one of the two groups of individuals, namely:
Consumers
Or Producers
The distribution of the tax burden depends upon the good itself and the price elasticity of demand or the elasticity of supply behind the product. When it comes to economics, elasticity refers to the extent to which a price change can cause changes in demand or supply.
Price elasticity of demandis the percent change in demand of a good relative to the percent change in price.
Price elasticity of supply is the percent change in the supply of a good relative to the percent change in price.
The introduction of new tax policies causes a change in the price of the goods, whether it is enforceable on the consumer or the supplier or both equally. Regardless of the tax imposition, a price change can profoundly affect consumer behavior. The price elasticity of supply and demand will determine the tax incidence economics and its imposition.
Graph
From the graphs given, we can understand the elasticity and tax incidence. Naturally, some goods are more elastic than others. For example, consider products people wouldn’t mind cutting out of the budget if the price increased, such as sports cars or superyachts. The tax burden on elastic goods will be more on the producers as the consumers will reduce their consumption due to a rise in the tax.
When a new tax falls on an elastic product, say sports cars worth over $250,000, individuals will most likely consider purchasing a vehicle slightly less than that threshold. It could force the dealers to take on the tax burden themselves to assure they won’t lose business over the new tax policy. Similarly, when the supply is elastic, i.e., when the producer uses price rise and offers more products, the consumers have to face the tax burden more.
The goods that people have a difficult time giving up are inelastic. Inelastic goods can be anything people depend on, like tobacco, prescription drugs, or alcohol. In that case, people will buy them regardless of the price rise. And therefore, the tax burden will lean more on the consumers.
Hence, both cases can be true. When products are inelastic, and consumers are willing to pay more, the tax burden can fall on them. Think about paying a utility bill. When the gas or electricity price increases, one still has to pay the bill to keep the lights on. If a new tax is presented on these utilities, they can pass the tax burden to the consumer. Similarly, when the supply is inelastic, the burden will fall upon the producers.
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Thus, the above explanation about elasticity and tax incidence clarifies the concept.
Formula
Usually, one can learn how to calculate tax incidence using simple subtraction. For example, in the above graph, the consumer tax incidence would have been P2-P1. The difference would have given the tax borne by the consumer on that particular good. The producer tax incidence would have been P2 – P3. The difference would have given the tax paid by the producer on that specific good.
The fixed formula for calculating the tax incidence could be as follows.
Consumer tax burden = Es/ Es + |Ed|
Supplier tax burden = Ed/ Ed + |Es|
Where:
E = elasticity
s= supply
d = demand
From the above formula, we understand how to calculate tax incidence.
Example
In this instance, let’s assume the government decides to impose a new luxury tax on yachts priced above $100,000. Let’s find out if the tax incidence falls more on the supplier or the consumer.
The new luxury tax calls for a 10% tax on the higher-priced yachts. However, the new tax also causes the demand for yachts to be cut in half from 100 to 50 to compensate.
We will start by finding the elasticity of supply and demand separately.
Elasticity of demand = % change in demand / % change in price
% change in demand is calculated as ((New Demand – Original Demand)/ Original Demand) X 100
= ((50 – 100)/ 100) X 100 = -50
This massive drop in demand has caused the supplier to cut back on supply from 150 to 100.
The elasticity of supply = (% change in supply/ % change in price)
The % change in supply is calculated as ((New Supply – Original Supply/ Original Supply) X 100
=((100 – 150/ 150) X 100
= (-50 / 150) X 100 = -33
We can now calculate the microeconomics tax incidence for the consumer and supplier to determine how much the new tax policy affects each group.
Consumer tax burden = Es/ Es + |Ed|
= -.33/ (-.33 + |-.50|)
= -.33 / -.83
= .40 or 40%
Supplier tax burden = Ed/ Ed + |Es|
= -.50/ (-.50 + |-.33|)
=-.50 / -.83
= .60 or 60%
In this case, the luxury tax has passed most of the new tax policy cost onto the supplier. This scenario happened in the United States after the government introduced a wealth tax, causing the yacht industry sales and jobs to decline sharply.
Tax Incidence Vs Tax Burden
Let us understand the difference between microeconomics tax incidence and tax burden.
The tax to be paid finally is the incidence whereas burden is the tax that will be paid now.
The tax that each citizen of a country pays is the burden but incidence is the way tax is distributed among all market participants.
Incidence can be shifted among market participants whereas each citizen should pay the burden which is a liability.
Frequently Asked Questions (FAQs)
What is tax incidence?
Tax incidence is the study of the distribution of the tax burden on producers and consumers. It measures the degree of original tax distribution and how it affects various groups of people in society.
How to calculate tax incidence on consumers?
When products are inelastic and the supply is elastic, the tax burden falls on the consumers. Therefore, the tax incidence on consumers can be calculated using the formula:
Tax burden= Es/ Es + |Ed| Where E= elasticity, S= supply, and D= demand
What determines tax incidence?
The tax incidence is determined by the price elasticity of supply and demand of a product. If the demand is more elastic than the supply, customers have to bear the high end of the tax burden and vice versa.
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