Tax Incidence: Definition, Example, and How It Works

Tax Incidence

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What Is a Tax Incidence?

"Tax incidence" (or incidence of tax) is an economic term for understanding the division of a tax burden between stakeholders, such as buyers and sellers or producers and consumers. Tax incidence can also be related to the price elasticity of supply and demand. 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.

Key Takeaways

  • A tax incidence describes a case when buyers and sellers divide a tax burden.
  • A tax incidence will also lay out who bears the burden of a new tax, for instance among producers and consumers, or among various class segments of a population.
  • The elasticity of demand of a good can help understand the tax incidence among parties.

How a Tax Incidence Works

The tax incidence depicts the distribution of the tax obligations, which 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.

Tax incidence reveals which group—consumers or producers—will pay the price of a new tax. For example, the demand for prescription drugs is relatively inelastic. Despite changes in cost, its market will remain relatively constant.

Levying New Taxes on Inelastic and Elastic Goods

Another example is that the demand for cigarettes is mostly inelastic. When governments impose a cigarette tax, producers increase the sale price by the full amount of the tax, transferring the tax burden to consumers. Through analysis, it is found the demand for cigarettes is unaffected by price. Of course, there are limits to this theory. If a pack of cigarettes suddenly increased from $5 to $1,000, consumer demand would fall.

If the levying of new taxes on an elastic good, such as fine jewelry, occurs, most 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. Elastic goods are goods with close substitutes or that are nonessential.

Price Elasticity and Tax Incidence

Price elasticity is a representation of how buyer activity changes in response to movements 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 profoundly impacts the level of demand, the demand is considered highly elastic.

Examples of inelastic goods or services can include gasoline and prescription medicines. The level of consumption across the economy remains steady with price changes. Elastic products are those whose demand is significantly affected by price. This group of products includes luxury goods, houses, and clothing.

The formula for determining the consumer's tax burden with "E" representing elasticity is as follows:

  • E (supply) / (E (demand)) + E (supply)

The formula for determining the producer or supplier's tax burden with "E" representing elasticity is as follows:

  • E (demand) / (E (demand) + E (supply))

What Does Tax Incidence Determine?

Tax incidence shows who or what ultimately bears the burden of a tax, as opposed to just who directly pays the tax.

Are Consumers or Retailers Impacted More By Tax Incidence?

A number of different parties can be impacted by tax incidence, such as when a consumer has to pay higher sales taxes, and therefore spends less at a retailer, ultimately hurting the retailer's sales and leading to job cuts or store closings.

What Is Elastic Vs. Inelastic Demand?

Elastic demand is demand that rises or falls based on the price of the service or product, state of the economy, or financial health of the person. Inelastic demand is demand that is, to an extent, impervious to price fluctuations, the state of the economy, tax incidence or any other financial consideration. It is the difference between something like entertainment or self-care purchases versus food and medicine.

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