Tax incidence

In economics, tax incidence or tax burden is the effect of a particular tax on the distribution of economic welfare. Economists distinguish between the entities who ultimately bear the tax burden and those on whom the tax is initially imposed. The tax burden measures the true economic effect of the tax, measured by the difference between real incomes or utilities 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, most of the tax burden is on buyers, not sellers. The concept of tax incidence was initially brought to economists' attention by the French Physiocrats, in particular François Quesnay, who argued that the incidence of all taxation falls ultimately on landowners and is at the expense of land rent. 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 (as opposed to the magnitude of the tax) is that the tax incidence or tax burden does not depend on where the revenue is collected, but on the price elasticity of demand and price elasticity of supply. As a general policy matter, the tax incidence should not violate the principles of a desirable tax system, especially fairness and transparency.^[1] 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.^[2]

The theory of tax incidence has a number of practical results. For example, United States Social Security payroll taxes are paid half by the employee and half by the employer. However, some economists think that the worker bears almost the entire burden of the tax because the employer passes the tax on in the form of lower wages. The tax incidence is thus said to fall on the employee.^[3] However, it could equally well be argued that in some cases the incidence of the tax falls on the employer. This is because both the price elasticity of demand and price elasticity of supply effect upon whom the incidence of the tax falls. Price controls such as the minimum wage which sets a price floor and market distortions such as subsidies or welfare payments also complicate the analysis.^{[citation needed]}

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.^[4] 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.^[5]

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.^[5]

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.^[6]

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:

$${\displaystyle {\dfrac {PES}{PES-PED}}}$$

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:

$${\displaystyle {\begin{aligned}{\dfrac {PES}{PES-PED}}&={\dfrac {0.5}{0.5-(-.0.4)}}\\\\&={\dfrac {0.5}{0.9}}\\\\&=56\%\end{aligned}}}$$

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:

$${\displaystyle {\begin{aligned}{\dfrac {-PED}{PES-PED}}&=-{\dfrac {-0.4}{0.5-(-.0.4)}}\\\\&={\dfrac {0.4}{0.9}}\\\\&=44\%\end{aligned}}}$$

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.^[7]

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.^[5]

A market with perfect competition is very rare. More of the market is said to be imperfect competition such as monopoly, oligopoly or monopolistic competition. Producers choose the level of output, at which marginal cost equals marginal revenue. The demand curve predicts the price level. After taxation, the marginal cost curve shifts to the left to reach a new equilibrium characterized by lower quantity and higher price than before (that is given by the downward slope of the demand curve and marginal revenue curve). Elasticity of the curves is still the essential factor that predicts the size of the tax burden levied on consumers and producers. In general, the steeper the marginal cost curve, the smaller the observed change in output after taxation. The difference between perfect competition and imperfect competition can be observed when the marginal cost curve is horizontal (perfect elasticity). Unlike under perfect competition, when the tax burden will be on consumer, in the case of imperfect competition the supplier and consumer will share the burden. The size depends on the elasticity of demand curve. For instance, if the demand curve is linear, the ratio is balanced half and half). Another difference lies in the ad valorem tax and specific tax. For any given revenue, the output from ad valorem tax will exceed the output from specific tax.^[5]

The supply and demand for a good is deeply intertwined with the markets for the factors of production and for alternate goods and services that might be produced or consumed. Although legislators might be seeking to tax the apple industry, in reality it could turn out to be truck drivers who are hardest hit, if apple companies shift toward shipping by rail in response to their new cost. Or perhaps orange manufacturers will be the group most affected, if consumers decide to forgo oranges to maintain their previous level of apples at the now higher price. Ultimately, the burden of the tax falls on people—the owners, customers, or workers.^[8]

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).^[5]

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.

Predominantly, studies of different distributions of the tax burden are carried out at a comparative level, either geographically (between different countries) or intertemporally (comparing distributions under different governments or regimes). The tax burden analysis aims to describe how different social classes contribute to the public sector.^[2]

In the United States, the analysis regarding how the tax burden affects each of its social classes is conducted regularly. The Congressional Budget Office presents a series of reports showing the share of all federal taxes paid by taxpayers at the same point in the income distribution. Their data for 2017 shows the following:

• The top 1% of the distribution pay 25% of all federal taxes.
• The highest quintile pays 87% of all individual income taxes and 69% of all federal taxes.^[13]

Assessing tax incidence is a major economics subfield within the field of public finance.

Most public finance economists acknowledge that nominal tax incidence (i.e. who writes the check to pay a tax) is not necessarily identical to actual economic burden of the tax, but disagree greatly among themselves on the extent to which market forces disturb the nominal tax incidence of various types of taxes in various circumstances.

The effects of certain kinds of taxes, for example, the property tax, including their economic incidence, efficiency properties and distributional implications, have been the subject of a long and contentious debate among economists.^[14]

The empirical evidence tends to support different economic models under different circumstances. For example, empirical evidence on property tax incidents tends to support one economic model, known as the "benefit tax" view in suburban areas, while tending to support another economic model, known as the "capital tax" view in urban and rural areas.^[15]

There is an inherent conflict in any model between considering many factors, which complicates the model and makes it hard to apply, and using a simple model, which may limit the circumstances in which its predictions are empirically useful.

• Effect of taxes and subsidies on price
• Excess burden of taxation
• Externalities and Pigovian taxes
• Fiscal incidence
• Flypaper theory of tax incidence
• Optimal tax
• List of countries by tax revenue as percentage of GDP