In economics, the tax incidence measures who actually pays for a tax. Economists distinguish between the entities who ultimately bear the burden of a tax (the real incidence) and those who the tax is originally collected from (the nominal incidence). The tax burden measures the true economic effect of the tax, measured by the difference between real incomes before and after imposing the tax, and taking into account how the tax causes prices to change. For example, if a 10% tax is imposed on sellers of butter, but the market price rises 8% as a result, then 80% of the tax incidence falls on buyers, not sellers.
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 the finding that the tax burden does not depend on where the revenue is collected, but on the price elasticity of demand and price elasticity of supply.
The concept of tax incidence is used in political science and sociology to analyze the level of resources extracted from each income social stratum in order to describe how the tax burden is distributed among social classes. That allows one to derive some inferences about the progressive nature of the tax system, according to principles of vertical equity.
The theory of tax incidence has a number of practical results. For example, United States Social Security payroll taxes are nominally paid half by the employee and half by the employer. However, economists generally find that workers bear most of the burden of the tax, because the employer passes it on in the form of lower wages. The tax incidence is thus said to fall mainly on the employee.
Tax incidence in competitive markets
In competitive markets, firms supply a quantity of the product such that the price of the good equals marginal cost (supply curve and marginal cost curve are indifferent). If an excise tax (a tax on the goods being sold) 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 (with higher price and lower quantity than initial 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 (from which the part of the tax is subtracted that producers will receive at given quantity. In Figure 1, the tax burden is borne equally by the producers and consumers. For example, if the initial price of the good is $2, and the tax levied on the production is $.40, consumers will be able to buy the good for $2.20, while producers will receive $1.80.
Consider the case when the tax is levied on consumers. Unlike when tax is imposed on producers, the demand curve shifts to the left to create new equilibrium with initial supply (marginal cost) curve. The new equilibrium (at a lower price and lower quantity) 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 (say ad valorem tax) or as a fixed sum per unit (say specific tax). 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.
Income taxes are taxes on the supply of labor (if the income is wages) or capital (if the income is dividends, for example). Corporate income tax incidence is difficult to evaluate because although the direct burden is on corporate shareholders, the tax tends to move capital to be supplied more to non-corporate uses such as housing or partnerships, reducing the return to capital generally, and it moves capital abroad, reducing wages. Thus, in the long-run, once the quantity of capital has adjusted, the incidence is likely on non-corporate capital as much as corporate capital, and much of it may be on labor. Economists' estimates of the incidence vary widely.Auerbach, Alan J. 2018. "Measuring the Effects of Corporate Tax Cuts." Journal of Economic Perspectives, 32(4):97-120. DOI: 10.1257/jep.32.4.97, p.99.
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 (apples) 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 (in the short run) 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). 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 phenomena, 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. As a general rule, the steeper the demand curve and the flatter the supply curve, the more the consumers will bear the tax. The flatter the demand curve and the steeper the supply curve, the more the producers will bear the tax.
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 (in the short run) 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 (between P without tax and P with tax); 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 (horizontal) or the demand curve is perfectly inelastic (vertical), 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 (the supply of improved land is elastic because more or less could be created by investment in improvements) or crude oil. Thus, the whole tax burden is on landowners and owners of the oil. The other factors that might affect tax incidence are the difference between the short-run and long-run and between open and closed economies.
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 (households) 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