Tax incidence

In economics, tax incidence is the analysis of the effect of a particular tax on the distribution of economic welfare. Tax incidence is said to "fall" upon the group that, at the end of the day, bears the burden of the tax. The key concept 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. For example, a tax on apple farmers might actually be paid by owners of agricultural land or consumers of apples.

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, economists think that the worker is bearing almost the entire burden of the tax because the employer passes the tax on in the form of lower wages. The tax incidence falls on the employee.

Simple, illustrative example

Imagine a $1 tax on every barrel of apples an apple farmer produces. If the apple farmer is able to pass the tax along to consumers of apples by raising the price $1, then consumers are bearing the entire burden of the tax. The tax incidence is falling on consumers. On the other hand, if the apple farmer can't raise prices, then the farmer is bearing the burden of the tax. The tax incidence is falling on the farmer. If the apple farmer can raise prices only $0.50, then they are sharing the tax burden. When the tax incidence falls on the farmer, this burden will flow back to owners of the relevant factors of production, including agricultural land.

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 (the group that has the most inelastic price-quantity curve). Austrian economist Ludwig von Mises teaches that the actual burden of any tax is determined by the market process rather than by the taxing authority. 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. Eventually, the tax incidence falls to the citizens in forms such as higher prices, lower wages, increased unemployment, decreased quality of goods, etc.

Graphical analysis

For a primer on reading supply and demand graphs, see: Supply and Demand.

For a primer on the economic effects of a tax, see: Tax.

Inelastic supply, elastic demand

Figure 1. This graph shows the imposition of a tax when there is an elastic demand curve and inelastic supply curve. The tax incidence falls mostly on the producer.

The following analysis examines the tax incidence of a tax collected from the producer in two different examples. In Figure 1, the blue supply curve is very inelastic (vertical, unresponsive to price) while the red demand curve is elastic (horizontal, responsive to price). The top blue supply curve is the supply curve after the tax is imposed, and the lower blue curve is before the tax is imposed. Because the producer (blue curve) is inelastic, he will produce the same quantity no matter what the price. Because the consumer is elastic, the consumer (red curve) 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 either the producer or consumer is inelastic, the quantity doesn't change much. Because the consumer is elastic and 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.

Inelastic demand, elastic supply

Figure 2. This graph shows the imposition of a tax when there is an inelastic demand curve and an elastic supply curve. The tax incidence falls mostly on the consumer.

Figure 2 tells a different story. Here the blue supply curve is very elastic (responsive to price) and the red demand curve is inelastic (unresponsive to price). The top blue supply curve is the supply curve after the tax is imposed, and the lower blue curve is before the tax is imposed. Because the consumer (red curve) is inelastic, he will demand the same quantity no matter what the price. Because the producer is elastic, the producer (blue curve) 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 either the producer or consumer is inelastic, the quantity doesn't change much. Because the consumer is inelastic and the producer is elastic, the price changes dramatically.

While the price change in Figure 1 is small, the price change in Figure 2 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, in Figure 2, the consumer is bearing the tax burden. In Figure 2, the tax incidence is falling on the consumer.

Clarification

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

Other practical results

The theory of tax incidence has a large number of practical results:

• Because businesses are more sensitive to wages than employees, payroll taxes, employer mandates, and other taxes collected from the employer end up being born by the employee. The tax is passed onto the employee in the form of lower wages.

• If the government requires employers to provide employees with health care, the burden of this will fall almost entirely on the employee because the employer will pass on the burden in the form of lower wages.

• Taxes on easily substitutable goods, such as oranges and tangerines, may be born mostly by the producer because the demand curve for easily substitutable goods is quite elastic.

• Similarly, taxes on a business that can easilly be relocated might be born almost entirely by the residents of the taxing jurisdiction and not the owners of the business.

• The burden of tariffs (import taxes) on imported cars might fall largely on the producers of the cars because the demand curve for foreign cars might be elastic.

• If consumers drive the same number of miles regardless of gas prices (which appears to be the case), then a tax on gasoline will be paid for by consumers and not oil companies. Who actually pays the tax is not affected by whether government collects the tax at the pump or directly from oil companies.

See also

• Effect of taxes and subsidies on price
• Fiscal incidence
• Flypaper theory (economics) of tax incidence
• Fiscal neutrality
• Tax policy