What is a 'Tax Incidence'

A tax incidence is an economic term for the division of a tax burden between buyers and sellers. Tax incidence is related to the price elasticity of supply and demand, and when supply is more elastic than demand, the tax burden falls on the buyers. If demand is more elastic than supply, producers will bear the cost of the tax.

BREAKING DOWN 'Tax Incidence'

The tax incidence represents the distribution of the tax obligations that must be covered by the buyer and seller. The level at which each party participates in covering the obligation shifts based on the associated price elasticity of the product or service in question as well as how the product or service is currently affected by the principles of supply and demand.

Price Elasticity

Price elasticity is a representation on how buyer activity is changed in response to a change in the price of a good or service. In situations where the buyer is likely to continue purchasing a good or service regardless of a price change, the demand is said to be inelastic. When the price of the good or service highly impacts the level of demand, the demand is considered highly elastic.

Examples of fairly inelastic goods or services can include gasoline, electricity and cigarettes. Even if prices change, the level of consumption across the economy remains fairly steady in all of the aforementioned examples. Elastic goods are those whose demand is greatly affected by price. This can include many luxury goods, such as precious metals, as well as large purchases, such as housing, and those with a variety of price points to choose from, such as clothing.

Analysis of Tax Incidence

Tax incidence reveals which group, the consumers or producers, will pay the price of a new tax. For example, the demand for cigarettes is fairly inelastic, which means that despite changes in price, the demand for cigarettes will remain relatively constant. Let's imagine the government decided to impose an increased tax on cigarettes. In this case, the producers may increase the sale price by the full amount of the tax. If consumers still purchased cigarettes in the same amount after the increase in price, it would be said that the tax incidence fell entirely on the buyers.

If a new tax was levied on a more elastic good, such as fine jewelry, the majority of the burden would likely shift to the producer as an increase in price may have a significant impact on the demand for the associated goods.

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