Tax incidence


In economics, tax incidence or tax burden is the effect of a particular tax on the distribution of economic welfare. Economists distinguish between the entities who ultimately bear the tax burden and those on whom tax is initially imposed. The tax burden measures the true economic weight of the tax, measured by the difference between real incomes or utilities before and after imposing the tax. An individuality on whom the tax is levied does not have to bear the true size of the tax. For the example of this difference, assume a firm, that contains employer and employees. The tax imposed on the employer is divided. The concept of tax incidence was initially brought to economists' attention by the French Physiocrats, in particular François Quesnay, who argued that the incidence of all taxation falls ultimately on landowners and is at the expense of land rent. Tax incidence is said to "fall" upon the group that ultimately bears the burden of, or ultimately suffers a loss from, the tax. The key concept of tax incidence is that the tax incidence or tax burden does not depend on where the revenue is collected, but on the price elasticity of demand and price elasticity of supply. As a general policy matter, the tax incidence should not violate the principles of a desirable tax system, especially fairness and transparency.
The theory of tax incidence has a number of practical results. For example, United States Social Security payroll taxes are paid half by the employee and half by the employer. However, some economists think that the worker bears almost the entire burden of the tax because the employer passes the tax on in the form of lower wages. The tax incidence is thus said to fall on the employee.
However, it could equally well be argued that in some cases the incidence of the tax falls on the employer. This is because both the price elasticity of demand and price elasticity of supply effect upon whom the incidence of the tax falls. Price controls such as the minimum wage which sets a price floor and market distortions such as subsidies or welfare payments also complicate the analysis.

Tax incidence in competitive markets

In competitive markets firms supply quantity of the product equals to the level at which the price of the good equals marginal cost. If an excise tax is imposed on producers of the particular good or service, the supply curve shifts to the left because of the increase of marginal cost. The tax size predicts the new level of quantity supplied, which is reduced in comparison to the initial level. In Figure 1 - a demand curve is added into this instance of competitive market. The demand curve and shifted supply curve create a new equilibrium, which is burdened by the tax. The new equilibrium represents the price that consumers will pay for a given quantity of good extended by the part of the tax
The point on the initial supply curve with respect to quantity of the good after taxation represents the price curve. The new equilibrium represents the price that producers will receive after taxation and the point on the initial demand curve with respect to quantity of the good after taxation represents the price that consumers will pay due to the tax. Thus, it does not matter whether the tax is levied on consumers or producers.
It also does not matter whether the tax is levied as a percentage of the price or as a fixed sum per unit. Both are graphically expressed as a shift of the demand curve to the left. While the demand curve moved by specific tax is parallel to the initial, the demand curve shifted by ad valorem tax is touching the initial, when the price is zero and deviating from it when the price is growing. However, in the market equilibrium both curves cross.
Corporate income taxes are taxes on profits. Since the consumer of the profit is the shareholder, it is the shareholder who pays the tax.

Example of tax incidence

Imagine a $1 tax on every barrel of apples a farmer produces. If the farmer is able to pass the entire tax on to consumers by raising the price by $1, the product is price inelastic to the consumer. In this example, consumers bear the entire burden of the tax—the tax incidence falls on consumers. On the other hand, if the apple farmer is unable to raise prices because the product is price elastic, the farmer has to bear the burden of the tax or face decreased revenues—the tax incidence falls on the farmer. If the apple farmer can raise prices by an amount less than $1, then consumers and the farmer are sharing the tax burden. When the tax incidence falls on the farmer, this burden will typically flow back to owners of the relevant factors of production, including agricultural land and employee wages.
Where the tax incidence falls depends on the price elasticity of demand and price elasticity of supply. Tax incidence falls mostly upon the group that responds least to price. If the demand curve is inelastic relative to the supply curve the tax will be disproportionately borne by the buyer rather than the seller. If the demand curve is elastic relative to the supply curve, the tax will be borne disproportionately by the seller. If PED = PES, the tax burden is split equally between buyer and seller.
Tax incidence can be calculated using the pass-through fraction. The pass-through fraction for buyers is:
So if PED for apples is -0.4 and PES is 0.5 then the pass-through fraction to buyer would be calculated as follows:
So 56% of any tax increase would be "paid" by the buyer; 44% would be "paid" by the seller. From the perspective of the seller, the formula is:

Elasticity and tax incidence

Compared to previous phenomenas, elasticity of the demand and supply curve is an essential feature, that predicts how much the consumers and producers will be burdened in the specific case of taxation. General rule claims, that the steeper is demand curve and the flatter is supply curve, the more of the tax will bear by consumers and the flatter is demand curve and the steeper is supply curve, the more of the tax will be bear by producers.

Inelastic supply, elastic demand

Because the producer is inelastic, they will produce the same quantity no matter the price. Because the consumer is elastic, the consumer is very sensitive to price. A small increase in price leads to a large drop in the quantity demanded. The imposition of the tax causes the market price to increase from P without tax to P with tax and the quantity demanded to fall from Q without tax to Q with tax. Because the consumer is elastic, the quantity change is significant. Because the producer is inelastic, the price doesn't change much. The producer is unable to pass the tax onto the consumer and the tax incidence falls on the producer. In this example, the tax is collected from the producer and the producer bears the tax burden. This is known as back shifting.

Elastic supply, inelastic demand

If, in contrast to the previous example, the consumer is inelastic, they will demand the same quantity no matter the price. Because the producer is elastic, the producer is very sensitive to price. A small drop in price leads to a large drop in the quantity produced. The imposition of the tax causes the market price to increase from P without tax to P with tax and the quantity demanded to fall from Q without tax to Q with tax. Because the consumer is inelastic, the quantity doesn't change much. Because the consumer is inelastic and the producer is elastic, the price changes dramatically. The change in price is very large. The producer is able to pass almost the entire value of the tax onto the consumer. Even though the tax is being collected from the producer the consumer is bearing the tax burden. The tax incidence is falling on the consumer, known as forward shifting.

Similarly elastic supply and demand

Most markets fall between these two extremes, and ultimately the incidence of tax is shared between producers and consumers in varying proportions. In this example, the consumers pay more than the producers, but not all of the tax. The area paid by consumers is obvious as the change in equilibrium price ; the remainder, being the difference between the new price and the cost of production at that quantity, is paid by the producers.

Special cases

When the supply curve is perfectly elastic or the demand curve is perfectly inelastic, the whole tax burden will be levied on consumers. An example of the perfect elastic supply curve is the market of the capital for small countries or businesses. In the instance of perfect elasticity of the demand or perfect inelasticity of the supply, the price will remain the same and the entire tax burden is on producers. An example of perfect inelastic supply curve is unimproved land or crude oil. Thus, the whole tax burden is on landowners and owners of the oil.
The other factors, that might affect the tax incidence is the difference between short-run and long-run and between open and closed economy.

The demand and supply for labor and tax incidence

All factors, which was derived on the tax incidence and competitive market might be used also in the case of market for labor. The key role of the paying the tax burden is still elasticity of the curves. Thus it does not matter, whether the tax is imposed on supplier or companies, which demand the labor as a factor of production. The tax leads to the lower wages and lower employment. However some economists assumes, that supply curve for the labor is backward-bending. It means, that the quantity of labor increases if the wages increase and from given level of the wage it started to decrease. The shape of the curve follows an idea, that high wages is an incentive to work less. So, if the tax is levied of this type of the market, it reduces the wages and therefore the quantity of labor rises.

Tax incidence without perfect competition

A market with perfect competition is very rare. More of the market is said to be imperfect competition such as monopoly, oligopoly or monopolistic competition. Producers choose the level of output, at which marginal cost equals marginal revenue. The demand curve predicts the price level. After taxation, the marginal cost curve shifts to the left to reach a new equilibrium characterized by lower quantity and higher price than before. Elasticity of the curves is still the essential factor that predicts the size of the tax burden levied on consumers and producers. In general, the steeper the marginal cost curve, the smaller the observed change in output after taxation. The difference between perfect competition and imperfect competition can be observed when the marginal cost curve is horizontal. Another difference lies in the ad valorem tax and specific tax. For any given revenue, the output from ad valorem tax will exceed the output from specific tax.

Macroeconomic perspective

The supply and demand for a good is deeply intertwined with the markets for the factors of production and for alternate goods and services that might be produced or consumed. Although legislators might be seeking to tax the apple industry, in reality it could turn out to be truck drivers who are hardest hit, if apple companies shift toward shipping by rail in response to their new cost. Or perhaps orange manufacturers will be the group most affected, if consumers decide to forgo oranges to maintain their previous level of apples at the now higher price. Ultimately, the burden of the tax falls on people—the owners, customers, or workers.
However, the true burden of the tax cannot be properly assessed without knowing the use of the tax revenues. If the tax proceeds are employed in a manner that benefits owners more than producers and consumers then the burden of the tax will fall on producers and consumers. If the proceeds of the tax are used in a way that benefits producers and consumers, then owners suffer the tax burden. These are class distinctions concerning the distribution of costs and are not addressed in current tax incidence models. The US military offers major benefit to owners who produce offshore. Yet the tax levy to support this effort falls primarily on American producers and consumers. Corporations simply move out of the tax jurisdiction but still receive the property rights enforcement that is the mainstay of their income.

Other considerations of tax burden

Consider a 7% import tax applied equally to all imports and a direct refund of every penny of collected revenue in the form of a direct egalitarian "Citizen's Dividend" to every person who files income tax returns. The import tax will increase prices of goods for all domestic consumers, compared to the world price. This increase in the price of goods will result in two types of dead-weight loss: one attributable to domestic producers being incentivized to produce goods that would be more efficiently produced internationally, and the other attributable to domestic consumers being forced out of the market for goods that they would have bought, had the price not been artificially inflated by the tariff. The actual cost of the tax will be borne by whichever party has the more inelastic demand, regardless of whether consumers buy domestic or foreign goods, and regardless of where the producers make their goods.

Tax burden of a country relative to GDP

A country or state's tax burden as a percentage of GDP is the ratio of tax collection against the national gross domestic product. This is one way of illustrating how high and broad the tax base is in any particular place. Some countries, like Denmark, have a high tax-to-GDP ratio. Other countries, like India, have a low ratio. Some states increase the tax-to-GDP ratio by a certain percentage in order to cover deficiencies in the state budget revenue. In states where the tax revenue has gone up significantly, the percentage of tax revenue that is applied towards state revenue and foreign debt is sometimes higher. When tax revenues grow at a slower rate than the GDP of a country, the tax-to-GDP ratio drops. Taxes paid by individuals and corporations often account for the majority of tax receipts, especially in developed countries.

Consumer and producer surplus

The burden from taxation is not just the quantity of tax paid, but the magnitude of the lost consumer surplus or producer surplus. The concepts are related but different. For example, imposing a $1000 per gallon of milk tax will raise no revenue, but this tax will cause substantial economic harm. When examining tax incidence, it is the lost consumer and producer surplus that is important. See the tax article for more discussion.

Effects on the budget constraint

Through the budget constraint might be seen, that uniform tax on wages and uniform tax on consumption have an equivalent impact. Both taxes shift the budget constraint to the left. New line will be characterized by same slope as the initial.

Other practical results

The theory of tax incidence has a large number of practical results, although economists dispute the magnitude and significance of these results:
Assessing tax incidence is a major economics subfield within the field of public finance.
Most public finance economists acknowledge that nominal tax incidence is not necessarily identical to actual economic burden of the tax, but disagree greatly among themselves on the extent to which market forces disturb the nominal tax incidence of various types of taxes in various circumstances.
The effects of certain kinds of taxes, for example, the property tax, including their economic incidence, efficiency properties and distributional implications, have been the subject of a long and contentious debate among economists.
The empirical evidence tends to support different economic models under different circumstances. For example, empirical evidence on property tax incidents tends to support one economic model, known as the "benefit tax" view in suburban areas, while tending to support another economic model, known as the "capital tax" view in urban and rural areas.
There is an inherent conflict in any model between considering many factors, which complicates the model and makes it hard to apply, and using a simple model, which may limit the circumstances in which its predictions are empirically useful.
Lower and higher taxes were tested in the United States from 1980 to 2010 and it was found that the periods of greatest economic growth occurred during periods of higher taxation. This does not prove causation. It is possible that the time of higher economic growth provided government with more leeway to impose higher taxes.