What is Tax Incidence and How is it Calculated?
Tax incidence helps to understand how the tax burden is shared between producers and consumers or buyers and sellers. This economic term can also be based on the price elasticity of demand and supply. The buyers bear the tax burden when supply is more elastic than demand. If the elasticity of demand is higher than supply, the tax burden falls on producers.
This article will help you understand what tax incidence means, how it works, and everything else you need to know about it.
What is Tax Incidence?
Tax incidence indicates who, among producers and consumers, will bear the tax burden. This distribution of tax burden varies based on the good and the price elasticity of demand or supply. Elasticity refers to the extent to which the price change can impact the demand and supply of goods.
In economics, supply and demand analysis is used to study tax incidence. Elasticity in demand or supply is their respective percentage change relative to the percentage change in price.
Tax incidence basically determines who bears the true weight of the taxes. The distribution of tax varies based on the situation. The initial tax incidence and final burden are different and their difference is called tax shifting.
The tax incidence also analyses the effects of new tax policies on consumers and producers due to price changes. The policies that increase the price elasticity of supply as compared to demand will increase the tax burden on consumers and those that increase the price elasticity of demand as compared to supply will increase the tax burden on producers.
How Does Tax Incidence Work?
Tax incidence works by figuring out who among the buyer and producer ultimately shoulders the tax burden rather than focusing on who pays it directly. Figuring this out is not as straightforward as it seems. Economists perform this analysis using varied models to determine the incidence of taxation. This assessment is complex and involves numerous factors together.
For instance, suppose the sales tax increases, and sometime later, the volume of purchases goes down. While the sales tax hike and the dip in purchases may be related, the dip may also be due to broader economic conditions. In such cases, the tax incidence may be overstated.
Sometimes, it may be easier to figure out the cause and effect of taxation. For example, there are sales tax holidays in some jurisdictions. During such times, sales tax is not levied on purchases below a specified amount for a brief span. It is easy to spot the change in buying behaviour during these times. Thus, one can figure out who bears the tax burden. If the revenue is significantly high during these sales-tax holidays, it shows the retailers could be bearing some of the sales taxes instead of the consumer paying the fees. The results may still not be 100% accurate as the consumers may move some of their normal buying from regular tax periods to these sales-tax holidays.
Also Read: What Is Input Tax Credit (ITC) In GST? Eligibility And Documents Required To Claim ITC
Tax Incidence Formula
The elasticities of demand and supply for most goods are neither completely elastic nor completely inelastic. They fall somewhere in between. This means that the consumer and producer share the tax burden. The incidence of taxation of either group can be computed only if the elasticity of demand and supply are known. Once the values have been computed, they are used to determine the consumer tax incidence using the formula below:
Consumer tax incidence = 100 * (Es / (Ed + Es))
Here,
Ed = the elasticity of demand
Es = the elasticity of supply
This formula helps to determine the percentage of the tax burden that the buyer bears. Below is the formula that determines the percentage of the tax burden that the producer/seller bears:
Producer tax incidence = 100 * (Ed / (Ed + Es))
The sum of consumer tax incidence and producer tax incidence is always 100%.
Tax Incidence: What is Equilibrium Quantity?
Equilibrium quantity is the number of products sold before the change in tax policy. It is an important factor in the calculation of tax incidence.
When the demand for goods is inelastic, consumers do not respond much to price changes and the demanded quantity sees only minor changes due to the introduction of taxes. Thus, the government can impose the tax burden on consumers by hiking prices without seeing a major decline in equilibrium quality.
For instance, if the tax on cigarettes increases, it doesn’t impact the demand. This is because consumer addiction drives sales. Since the demand is inelastic, the consumers bear the tax burden and there isn’t any notable decline in equilibrium quantity.
Similarly, when the taxes are introduced in a market with an inelastic supply, the tax burden is borne by sellers without affecting the equilibrium quantity. This is because the seller has no other option than to accept lower prices.
How to Calculate Tax Incidence?
The following values are required to calculate tax incidence:
Pc: the price paid by consumers
Pp: price received by producers
Pe: equilibrium price before the introduction of tax
Tax incidence on consumers= Pc-Pe
Tax incidence on producers= Pe-Pp
Here is how the tax incidence is calculated in different cases:
Case 1: Demand is more elastic than supply
Incidence of tax on consumers < Tax incidence on producers
Case 2: Supply is more elastic than demand
Tax Incidence on consumers > Incidence of tax on producers
Example of Tax Incidence
Here is an example of the demand and supply of a luxury yacht in the US market. Let’s assume the government imposed a wealth tax on yachts priced above $1,00,000. Here is how to find out if the tax burden is more on the yacht supplier or buyer.
Higher-priced yachts were taxed at 10%. This caused the demand for yachts to dip to half (Let us assume the demand dip from 100 to 50)
The next step is to calculate the values of elasticity of supply and demand.
Elasticity of demand = % change in demand / % change in price
Ed= ((50 – 100)/ 100) X 100 = -50
This demand drop led the supplier to reduce the supply from 150 to 100
The elasticity of supply = (% change in supply/ % change in price)
Es= ((100 – 150/ 150) X 100 = -33
We can now use these values to calculate the incidence of tax on both consumers and suppliers to assess the impact of the new tax policy on each group.
Tax burden on consumer= Es/ Es + |Ed|
= -.33/ (-.33 + |-.50|)
= -.33 / -.83
= .40 or 40%
Tax burden on supplier = Ed/ Ed + |Es|
= -.50/ (-.50 + |-.33|)
=-.50 / -.83
= .60 or 60%
Thus, the burden of tax caused by the new tax policy has been passed to the supplier. This happened in the United States after the government introduced the wealth tax. This led to a decline in sales and jobs in the yacht industry.
How Does Tax Incidence Change with Elasticity?
All goods differ in elasticity. Some are more elastic because the buyers won’t mind excluding them from the budget in case of a price increase. For instance, the yacht example above shows how demand is reduced. Thus, producers bear the tax burden on elastic goods as consumers reduce consumption due to the tax hike. This is because they do not want to lose business because of the new tax policy. On the other hand, elastic supply puts the tax burden on consumers.
The products that are not easy to give up are inelastic. This includes alcohol, tobacco, cooking oil, prescription drugs or anything that the consumers depend on. The dependency leads them to buy irrespective of price rise. Thus, they have to shoulder the tax burden.
Impact of Tax Incidence on Individuals
Tax incidence indicates the true cost of adjusting the taxes. Some taxes may seem fine at the onset, but looking at who ultimately pays the cost can help to get the right picture of the consequences. Policymakers can use tax incidence to introduce taxes that have an incidence on the party paying the taxes upfront. Other citizens can use tax incidence to make voting choices.
Also Read: How To Pay Income Tax Online: 4 Advantages Of Income Tax E Payment
Final word
The person paying the taxes directly to the government doesn’t always bear the ultimate cost of the tax. Incidence of tax refers to the distribution of tax burden among producers and consumers. Tax incidence can affect multiple parties. For instance, the tax burden on retailers may lead to lower employee pay or job losses. Economists are divided on their opinion on tax incidence and its calculation may not always be straightforward. Economists use different models to determine incidence.
FAQs
Ans. Tax incidence studies how the tax burden is shared between producers and consumers. It is a measure of the extent of tax distribution and its impact on different people in society.
Ans. Consumers bear the tax burden when supply is elastic and products are inelastic. Here is the formula to calculate tax incidence on consumers:
Tax burden= Es/ Es + |Ed|
Here Es= elasticity of supply
Ed= elasticity of demand
Ans. Elasticity refers to the extent to which a price change can affect demand and supply. Elasticity determines who bears the tax burden.
Ans. The elasticity of demand and supply determines the tax incidence. When the elasticity of supply is less than the elasticity of demand, customers need to bear most of the tax burden. On the contrary, sellers bear the tax burden when the elasticity of demand is lesser than the elasticity of supply.
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.Disclaimer
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