# Tax incidence

First discussed by the Physiocrats in France, tax incidence is the analysis of the effect of a particular tax on the distribution of economic welfare.

Tax incidence also refers to the ultimate payer of a tax. If a government increases tax on petrol, oil companies may absorb it if competition is intense or they may pass it on to private motorists.

Similarly, a taxi driver may pass on the tax increase to his passenger and a food distributor may pass it on to a supermarket, which in turn passes it on to its customer.

Also see: equal sacrifice theory, ability to pay principle

Source:
J A Pechman, Who Paid the Taxes, 1966-85? (Washington, D.C., 1985)

## Tax incidence in competitive markets

Figure 1 – tax incidence in perfect competition

In competitive markets firms supply quantity of the product equals to the level at which 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.[3] 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 {\displaystyle (p_{0}+kt),k\in [0,1].}

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 {\displaystyle (p_{0}-(1-k)t),k\in [0,1])} that producers will receive at given quantity. In this case, 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.[4]

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.[4]

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.[5]

## Effects on the budget constraint

Through the budget constraint might be seen, that uniform tax on wages and uniform tax on consumption have an equivalent impact. Both taxes shift the budget constraint to the left. New line will be characterized by same slope as the initial (parallelism).[4]

## 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:

• If the government requires employers to provide employees with health care, some of the burden will fall on the employee as the employer will pass it on in the form of lower wages. Some of the burden will be borne by employer (and ultimately the customer in form of higher prices or lower quality) since both the supply of and demand for labor are highly inelastic and have few perfect substitutes. Employers need employees largely to the extent they can substitute employees for machines, and employees need employers largely to the extent they can become self-employed entrepreneurs. An uneducated population is therefore more susceptible to bearing the burden because they are more easily replaced by machines able to do unskilled work, and because they have less knowledge of how to make money on their own.
• 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 to 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 vehicles 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, 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). 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.

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