Incidence of Tax

Have you ever thought to yourself when hearing the news about additional taxes levied on firms: 'Yes, that's great! Finally, the companies will bear more of the tax burden. That's how it should be!' We are here to tell you that you shouldn't be happy about it. In fact, an incidence of an excise tax, which sales taxes often are, doesn't depend on whom the tax is officially levied. It depends on who actually ends up paying it. And if this did not cause you to stop for a moment, here's the punchline: you may be the one paying a part of the taxes that are actually levied on firms. How? Read on to find out!

Incidence of Tax Incidence of Tax

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Table of contents

    Economics Incidence of Tax

    Before diving into the economics of tax incidence, let's first try to understand what tax incidence is. The easiest way to do so is by analyzing sales tax or excise taxes in general.

    Excise taxes are taxes on the sale of goods and services levied per unit of the product sold.

    There are many examples of products on which excise taxes are levied. Gasoline, sugary drinks, and cigarettes are examples of goods taxed in the U.S.

    The average gas tax rate in the U.S. was about 28 cents per gallon in 2020.1

    In 2017 Philadelphia became one of the first cities in the United States to introduce a tax on sugary drinks. The result was a more than 20% reduction in the consumption of sugary drinks.2

    Most goods and services in the UK, besides food and children's clothing, are subject to a 20% VAT (value-added tax) rate.3

    Tax incidence meaning

    We are now ready to finally cover the meaning of tax incidence. We know that the tax is charged per unit of output sold. The government can levy the tax on either the producer or the consumer. But we will see that the imposition of tax creates certain distortions in the market.Because of these distortions to market equilibrium, the tax may not actually be paid exclusively by one party as the government intended. The extent to which a party pays a portion of the tax burden is what tax incidence measures.

    Tax incidence is a measure that defines who actually pays the tax.

    Impact and Incidence of Tax

    The impacts of a tax incidence depend on many factors. The tax can be initially levied on the producer or the consumer. The demand or supply can be relatively elastic or inelastic. Let's take a closer look at two of the possibilities in turn:

    1. When the tax is levied on a producer
    2. When the tax is levied on the consumer

    Incidence of tax: a tax levied on the producer

    When a tax is levied on a producer, the supply curve will shift leftward. The price level for each quantity will be higher by the amount of tax. The equilibrium quantity will decrease, with consumers paying the higher price and suppliers receiving a lower price due to them paying the tax. The tax burden is shared by the consumer and producer. In other words, the tax is partially paid for by the consumer and partially by the producer. We can then say that the tax incidence for a producer can be measured by the decrease in the price they receive after the imposition of tax.

    Tax incidence for a producer is reflected by how much the price they receive decreases after the imposition of tax.

    Let's take a look at Figure 1 below to visualize it better.

    Incidence of Tax A tax levied on the producer StudySmarterFig. 1 - A tax levied on the producer

    Figure 1 above shows a tax imposed on a seller. This shifts the supply curve leftward from S0 to Stax. Price P0 and quantity Q0 correspond to the initial equilibrium. After the tax, the price level is higher for each quantity by the amount of tax, which is equal to the vertical distance between the supply curves. The quantity decreases from Q0 to Qtax.

    Officially, the producer pays the tax, but actually, the consumer shares in paying the tax as well. The consumer burden area represented in purple shows how much in total consumers share in paying the tax. They now pay a higher price - Ptax compared to P0, while the producer receives P1 after paying the government the tax. They receive (P0-P1) less per unit than the amount they would receive previously. In this example, the consumer and producer burdens are equal, but this may not necessarily always be the case.

    Incidence of tax: a tax levied on the consumer

    If the government taxes a consumer instead of a producer, the demand curve will shift leftward. Because the consumers are now paying the tax on their purchases, the final price will correspond to the old demand curve. Therefore the price level for each quantity will be higher by the amount of tax. Equilibrium quantity will fall, and consumers will be faced with higher prices. Suppliers, again, will receive a lower actual price corresponding to the new equilibrium price. The tax burden will once again be shared by the consumer and producer. The consumer tax incidence can be measured by an increase in the price that results from the imposition of tax.

    Tax incidence for a consumer is reflected by how much the final price they pay changes after the imposition of tax.

    Because we are economists, let's analyze this case with a diagram! Take a look at Figure 2 below.

    Incidence of Tax A tax levied on the consumer StudySmarterFig. 2 - A tax levied on the consumerFigure 2 above depicts a tax imposed on a consumer. Price P0 and quantity Q0 correspond to the initial equilibrium. The tax shifts the demand curve leftward from D0 to Dtax. The price level is now higher for each quantity by the amount of tax, which is equal to the vertical distance between the demand curves. The quantity decreases from Q0 to Qtax. The producer burden area in yellow shows how much in total producers share in paying the tax. Consumers now pay a higher price - Ptax compared to P0, while the producer receives P1. They receive (P0-P1) less per unit than the amount they would receive previously. Again, the consumer and producer burdens are equal here, but they don't always have to be.

    Tax incidence analysis

    Having seen the tax incidence outcomes in cases when the tax is levied on a producer and consumer, we are now ready to turn to tax incidence analysis. The producer and consumer burden may be equally shared between the two parties. However, it doesn't always have to be the case.The extent of the burden shared by the consumer and the producer depends on the relative price elasticities of demand and supply. Let's summarize the effects of taxes on the producer and consumer for all the cases of demand and supply elasticities.If demand is relatively more price elastic than supply, the producers will bear more tax burden. Let's take a look at Figure 3 below.

    To learn more about the price elasticity of supply, check our article - Price Elasticity of Supply.

    Incidence of Tax Tax incidence when demand is more elastic than supply StudySmarterFig. 3 - Tax incidence when demand is more elastic than supply

    Figure 3 above shows an example of a tax imposed on the producer. Because the demand is more price elastic than supply, the quantity demanded drops significantly (from Q0 to Qtax) compared to the price increase (from P0 to Ptax). However, for the producer, the price drops significantly (from P0 to P1) compared to the quantity decrease. This results in the producer burden, represented by the yellow area, being more prominent than the consumer burden, represented by the purple area.If demand is relatively less price elastic than supply, the consumers will bear more tax burden. Let's observe this in Figure 4 below.

    To learn more about the price elasticity of demand, check our article - Price Elasticity of Demand.

    Incidence of Tax Tax incidence when supply is more elastic than demand StudySmarterFig. 4 - Tax incidence when supply is more elastic than demand

    Figure 4 above shows an example of a tax imposed on the producer. Because the demand is less price elastic than supply, the quantity demanded drops slightly (from Q0 to Qtax) compared to the price increase (from P0 to Ptax). On the other hand, the price the producer receives drops insignificantly (from P0 to P1) compared to a decrease in the quantity. This results in the consumer burden, represented by the purple area, being more significant than the producer burden, represented by the yellow area.The key takeaway is that the tax incidence does not depend on who officially pays the tax to the government.

    We invite you to learn more about taxes in our articles:- Progressive Tax system- US Tax- UK Taxes- State and Local Tax- Federal Taxes

    Example of Tax Incidence

    Let's take a look at some numerical examples of tax incidence. We can take each of the two cases in turn:

    1. Tax levied on the producer
    2. Tax levied on the consumer

    Example of tax incidence: a tax levied on the producer

    Imagine a tax levied on the sale of sugary drinks. The initial price is $5.00, and the quantity demanded is 90 units. A surcharge of $0.30 per bottle is imposed on the producer. The new price of drinks is $5.10 per bottle, and the new quantity demanded is 80 units. After the producers pay the tax to the government, they are left with $4.80 per unit sold. This scenario is illustrated in Figure 5 below.

    Incidence of Tax Example of a tax levied on the producer StudySmarterFig. 5 - Example of a tax levied on the producer

    Calculate the producer and consumer burden.We are given the following values:\(P_0=\$5.00\)\(Q_0=90\)\(P_t=\$5.10\)\(Q_t=80\)\(P_1=\$4.80\)\(T=\$0.30\)\(\hbox{Where:}\)\(P_0=\hbox{Initial price}\)\(Q_0=\hbox{Initial quantity}\)\(P_t=\hbox{After-tax price}\)\(Q_t=\hbox{After-tax quantity}\)\(P_1=\hbox{After-tax price that producer receives}\)\(T=\hbox{tax per unit}\)

    \(\hbox{Producer burden}=(P_0-P_1) \times Q_t=(\$5.00-\$4.80)\times80=16\)\(\hbox{Consumer burden}=(P_t-P_0) \times Q_t=(\$5.10-\$5.00)\times80=8\)

    In the example above, the producer bears more tax burden than the consumer.

    Example of tax incidence: a tax levied on the consumer

    Imagine a tax levied on the consumption of cigarettes. The initial price is $5.00, and the quantity demanded is 50 units. A surcharge of $0.50 per pack is imposed on the consumer. The new price of cigarettes is $5.30 per pack, and the quantity demanded is now 40 units. After the consumers pay the tax to the government, producers are left with $4.80 per unit sold. This scenario is illustrated in Figure 6 below.

    Incidence of Tax Example of a tax levied on the consumer StudySmarterFig. 6 - Example of a tax levied on the consumer

    Calculate the producer and consumer burden.We are given the following values:\(P_0=\$5.00\)\(Q_0=50\)\(P_t=\$5.30\)\(Q_t=40\)\(P_1=\$4.80\)\(T=\$0.50\)\(\hbox{Where:}\)\(P_0=\hbox{Initial price}\)\(Q_0=\hbox{Initial quantity}\)\(P_t=\hbox{After-tax price}\)\(Q_t=\hbox{After-tax quantity}\)\(P_1=\hbox{After-tax price that producer receives}\)\(T=\hbox{tax per unit}\)

    \(\hbox{Producer burden}=(P_0-P_1) \times Q_t=(\$5.00-\$4.80)\times40=8\)\(\hbox{Consumer burden}=(P_t-P_0) \times Q_t=(\$5.30-\$5.00)\times40=12\)

    In the example above, the consumer bears more tax burden than the producer.

    Eager to deep dive into more topics on tax and tax policy? Look no further than our articles:- Deadweight Loss- Tax Compliance- Marginal Tax Rate- Lump Sum Tax- Tax Equity- Incidence of Tax

    Incidence of Tax - Key takeaways

    • Tax incidence is a measure that defines who actually pays the tax.
    • Tax incidence for a producer is reflected by how much the price they receive decreases after the imposition of tax. Tax incidence for a consumer is reflected by how much the final price they pay changes after the imposition of tax.
    • Excise taxes are taxes on the sale of goods and services levied per unit of the product sold.
    • If demand is relatively more price elastic than supply, the producers will bear more tax burden.If demand is relatively less price elastic than supply, the consumers will bear more tax burden.

    References

    1. Statista, Gas tax and price of leading states based on highest effective gasoline tax in the United States as of March 2022, https://www.statista.com/statistics/509649/us-states-with-highest-gas-tax-and-prices/
    2. Reuters, First U.S. soda tax cuts consumption beyond expectations, 2016, https://www.reuters.com/article/us-health-soda-tax-idUSKCN12S200
    3. GOV.UK - VAT rates, https://www.gov.uk/vat-rates
    Frequently Asked Questions about Incidence of Tax

    What is meant by the incidence of a tax?

    Tax incidence is a measure that defines who actually pays the tax.

    What are the types of incidence of tax?

    The two types of tax incidence are tax incidence on the producer and tax incidence on the consumer.

    What is the importance of tax incidence?

    The importance of tax incidence is that who actually pays the tax does not depend on who officially is required to pass the tax payment to the government.

    What are the factors determining the incidence of tax?

    The factors determining the tax incidence are the relative price elasticities of demand and supply.

    Can the incidence of tax be shifted?

    Tax incidence can be shifted from producers to consumers and vice versa.

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