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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.^[1]

[edit] Simple Example of Tax Incidence

Imagine a $1 tax on every barrel of apples an apple farmer produces. If the product (apples) is price inelastic to the consumer, where if price rose, a small demand loss will be accounted for by the extra revenue. Then the farmer is able to pass the tax along to consumers of apples by raising the price by $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, because the product is price elastic, where if price rose, more demand will be lost than the extra revenue made, the farmer will bear 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 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 (the group that has the most inelastic price-quantity curve).

[edit] 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.

Figure 1. Elastic demand and inelastic supply. The tax incidence falls mostly on the producer.

[edit] Inelastic supply, elastic demand

Because the producer is inelastic, he will produce the same quantity no matter what 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 producer 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. This is known as back shifting.

Figure 2. Inelastic demand and elastic supply. The tax incidence falls mostly on the consumer.

[edit] Inelastic demand, elastic supply

Because the consumer is inelastic, he will demand the same quantity no matter what 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.

[edit] Tax Burden in Larger Scope

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.^[2]

[edit] 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 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.

[edit] 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:

• Because businesses are more sensitive to wages than employees, payroll taxes, employer mandates, and other taxes collected from the employer end up being borne 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 is likely fall on the employee to a great degree because the employer may pass on the burden in the form of lower wages.

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

• Similarly, taxes on a business that can easily be relocated are likely be borne 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 car consumers may substitute a domestic car purchase for a foreign car purchase.

• If consumers drive the same number of miles regardless of gas prices (which appears to be the case in the short run), then a tax on gasoline will be paid for by consumers and not oil companies (this is assuming that the price elasticity of supply of oil is high, which is incorrect. In this case both the price elasticity of demand and supply are very low). Who actually bears the economic burden of the tax is not affected by whether government collects the tax at the pump or directly from oil companies.

[edit] Controversy

Assessing tax incidence is a major subfield within Economics of the field of Public Finance.

Most public finance economists acknowledge that nominal tax incidence (i.e. who cuts the check to pay a tax) 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.^[3]

The empirical evidence tends 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.^[4]

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.

[edit] See also

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

[edit] Notes

1. ^ International Burdens of the Corporate Income Tax
2. ^ The Tax Foundation - Who Really Pays the Corporate Income Tax?
3. ^ See, e.g., Zodrow GR, Mieszkowski P. "The Incidence of the Property Tax. The Benefit View vs. the New View". In: Local Provision of Public Services: The Tiebout Model after Twenty-Five Years—Zodrow GR, ed. (1983) New York: Academic Press. 109–29.
4. ^ Zodrow, The Property Tax Incidence Debate and the Mix of State and Local Finance of Local Public Expenditures (2008), citing Fischel, Regulatory Takings: Law, Economics, and Politics (1995)