Factors influencing incidence of Taxation

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 tax is initially imposed. The tax burden measures the true economic weight of the tax, measured by the difference between real incomes or utilities before and after imposing the tax, taking into account how the tax leads prices to change. If a 10% tax is imposed on sellers of butter, for example, but the market price rises 8% as a result, most of the 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 Nature of a Tax:

The nature of a tax as to whether it is a tax on the production or sale of some commodities or it is a personal income or property tax. Tax shifting can easily take place in the case of taxes on the production and sale of commodities. The taxes on pro­duction or sale of commodities are called indirect taxes. The important examples of indirect taxes are excise duties and sales tax. On the other hand, the burden of direct taxes such as income and wealth taxes cannot be shifted.

2. Market Conditions:

Whether commodity is being produced under conditions of perfect competition, monopolistic competition or monopoly goes to determine the extent to which the burden of the tax can be shifted. A monopolist who has a full control over the supply of a commodity is in a better position to shift the burden of a tax on the commodity produced.

Likewise, a producer working under monopolistic competition who produced a product somewhat different from others exercises a good deal of influence over the price of its product and therefore can pass on a part of the burden of the tax to the buyers.

Even the firms working under perfect competition can shift the tax burden as the tax levied on a commodity raises its supply price for all of them. The difference in the three market forms lies in the extent to which the burden of the tax can be shifted.

3. Physical Conditions of Production:

The shifting of the tax burden on a commodity also depends upon whether the commodity is being produced under increasing, constant or diminishing returns. This will be explained in detail a little later.

Factors Determining Incidence of Indirect (Commodity) Taxes:

The questions of tax shifting especially arise in the case of indirect taxes, that is, taxes on the production and sale of goods such as excise duties and sales tax. In this regard, whether and to what extent a tax on commodity can be shifted depends on the price elasticity of demand for and supply of a commodity.

It is these elasticity’s of demand and supply that determine the bargaining strengths of the sellers and buyers of the taxed commodity. Sellers can shift the tax burden to the buyers if they are able to re­duce the supply of the commodity and thereby raise its price.

Thus, the power to shift the tax depends on the elasticity of supply of the taxed commodity. The elas­ticity of reducing supply of a commodity will be relatively smaller if there is excess capacity in the industry producing it. Fur­ther, the elasticity of supply of a commod­ity will be larger in the long run than in the short run.

Apart from the elasticity of supply, power to transfer the tax burden depends on the-elasticity of demand for a commod­ity. The greater the elasticity of demand of the buyers, the smaller the extent to which the tax will be shifted to them.

1. Elasticity of Demand:

Elasticity of demand affects the shifting process. If the taxed com­modity is having perfectly elastic demand price cannot be raised at all.

Hence the incidence will be wholly on the seller. On the other hand, when the demand is perfectly inelastic, the incidence will be wholly on the buyer. In between these two extremes, the incidence of tax will be shared by the buyer and seller.

2. Elasticity of Supply:

Price is determined by the interaction between demand and supply of a commodity. Hence incidence of a tax will be fully borne by the buyer, when the taxed commodity is having perfectly elastic supply. Likewise, when the supply of a commodity is perfectly inelastic, the whole incidence will be on the seller.

3. Price acts an Engine of Shifting:

Price act as a media of shifting. It is the vehicle, which carries money burden of tax from the point of view of legal liability. If the tax is shifted through a raise in price, it is called forward shifting. If the price cannot be rise, tax cannot be shifted. Hence the character of price flexibility is the most important factor that determines the shift- ability of a tax.

4. Tax Area:

The nature of the area in which the tax is imposed also affect shifting of a tax. If the tax is imposed on a commodity, having local market, it will be difficult to shift the tax by raising the price.

In such a case, people can avoid the tax by purchasing a commodity from neighborhood market, where it is cheap. This also gives rise to smug­gling of commodities from non-tax levying locality to avoid taxes.

5. Time Period:

Time factor influence the shift ability of a tax. In the short period supply is inelastic. Hence, during this period greater part of tax bur­den will be borne by the seller.

In the long-run, supply is more elastic. Hence, there is a better scope for shifting tax burden upon the buy­ers. Therefore, in the short period, shifting of a tax is difficult, where as in the long period it is easy to do.

6. Coverage of Tax:

If the tax is general in character, falling on wide range of commodi­ties, it is easy to shift the burden.

For example, if the tax levied on tooth paste is general in nature, covering all brands and kinds, it will be readily shifted.

However, if a tax is imposed on one brand of tooth paste, excluding the other brands, it is not possible to shift the tax burden. So we can say that shifting of a tax is rendered easier in general tax than in non-general taxes.

7. Availability of Substitutes:

Taxes imposed on a commodity having no close substitutes, can be easily shifted to the buyer. Here the buyer cannot find an alternative product as substitute to satisfy his demand.

Hence, he will be ready to purchase the taxed commodity by giving higher prices. On the other hand, if the taxed product has close substitute, shifting the money burden to buyers, is difficult.

Any rise in price due to tax will be opposed by the buyer, and he will go for the non-taxed substi­tutes. So the seller will himself bear the burden of tax, instead of attempting to shift it.

8. Nature of Demand for Commodities:

By this, we mean whether the taxed commodity is falling under the category of necessaries, comforts or luxuries. The nature of demand is different for different commodities. In the case of necessary goods, demand is inelastic.

Hence the burden of tax is higher upon the buyer, than on seller. In the case of comforts, demand is more elas­tic, hence burden of tax will be divided between buyer and seller. Coming to the case of luxuries, demand is elastic. Hence the bur­den of tax is more on the seller. It cannot be easily shifted to the consumers.

9. Business Conditions:

Shifting of a tax is influenced by the existing business condition in the economy. During periods of rising prices and economic prosper­ity, taxes can be shifted more easily. However, during periods of depression, forward shifting of tax liability is very difficult. Depres­sion is a situation of falling prices. Seasonal changes also will affect the shifting of tax.

10. Types of Tax:

Shifting depends upon nature or type of tax imposed. If a tax is imposed on the excess profits of a firm under monopoly or imperfect competition, the incidence will not be shifted. On the other hand, if the tax is levied on the output of the firm, a part of incidence can be shifted on to the consumers.

11. The Policy of the Government:

Shift ability of a tax is determined by the tax laws and public policy. In India, a tax law clearly indicates the price to be charged and to be printed on the product cover. For example, sales tax legislation stipu­lates that the burden of sales tax is to be borne by the consumers.

Likewise, government fixes maximum retail price and through law makers it binding to print it on the product. Then those who charge higher prices are legally punished. Hence, whenever a tax is im­posed the law abiding citizen will pay it rationally.

On the other hand, if prices are increased due to the attempt to shift some taxes to be paid by the seller, awareness of tax laws helps the consumer to resist it.

12. Market Conditions:

Shifting of a tax is influenced by the conditions of market for the product taxed.

The theory of shifting can be analyzed under:

(a) Per­fection competition,

(b) Monopoly, and

(c) Monopolistic competition.

(a) Shifting Under Perfect Competition:

Given the assumptions of perfect competition, the price is deter­mined by the interaction of demand and supply. The demand curve faced by each firm is perfectly elastic. Hence, a tax imposed cannot be shifted forward by increasing the price of the taxed commodity.

Likewise, the tax cannot be shifted backward because the supply of the factors is also perfectly elastic. However, the incidence of tax can be shifted in the long-run by reducing the supply and thereby raising the price of the commodity.

Moreover, if the taxed commodity is perishable, its supply curve is perfectly inelastic and the entire tax burden will be borne by the sellers. If the taxed commodity is of durable nature, the entire tax burden can be shifted forward to the buyers.

(b) Shifting under Monopoly:

Under conditions of monopoly, a tax on the monopolist will certainly increase the cost of production. But the incidence sharing between the monopolists and consumers will depend upon the respective elasticity of demand and supply of the commodity produced by the monopolist.

Theoretically, the profit will be at the maximum, when marginal revenue equals marginal cost and price is higher than ei­ther. Any tax on the monopolist which raises his marginal cost would cause him to reduce his output and raise his price.

The extent to which the monopolist would succeed in shifting the burden of a tax depends on three factors.

They are:

(1) The nature of the tax

(2) The nature of the demand for the article

(3) The cost condition under which production takes place.

If a tax is levied upon profit or sales, the monopolists cannot shift the burden on to the consumers. This is because the position of costs and revenue curves cannot be changed according to his favour.

If the taxed commodity is having inelastic demand, the entire burden of tax will fall on con­sumers. Contrary, if the demand for the taxed commodity is elastic, the entire burden of tax will fall on monopolies.

Likewise if the supply of monopolist product is inelastic, the burden of tax will fall on the monopolist. If supply is elastic, the entire burden of tax will be on the consumer. On the other hand if the demand for the monopolist prod­uct is more elastic than its supply, the burden of tax will fall more on the monopolist, than on consumers.

In a situation, when demand is less elastic than its supply, the monopolist will bear less burden of tax than the consumers. A monopolist can be taxed in three differ­ent ways. A tax can be imposed, proportionate to output, a tax can be imposed independent of output produced or a tax can be im­posed which diminish with an increase in output.

When the tax is independent of production and is levied on profit, it is difficult to shift. The output before the levy of tax would have been adjusted, to yield the minimum profit. The monopolist may have a greater profit after paying the tax by leaving the price unchanged.

When a tax is im­posed in proportion to output, a partial shifting of the tax is possible, as it increases the marginal cost of the monopolists firm. When the tax diminishes with the increase in output, the monopolist will in­crease his output and reduce the price of the commodity, produced by him. In this case the monopolist will bear the entire burden of the tax.

Any definite conclusion cannot be arrived at in the matter of the shifting of the tax under monopoly conditions. The reason is that, perfect monopoly is a very rare phenomenon. Moreover, the mo­nopolist usually will not charge the theoretical monopoly price.

The monopolist will always fix a price lower than this level, owing to the threat of governmental intervention or emergence of competitive ele­ment.

(c) Shifting Under Monopolistic Competition:

Monopolistic competitions is characterized by few firms in produc­tion arena, existence of product differentiation and a situation in which price is determined by the price leaders. In such markets one or two firms may act as the price leaders.

Hence if a tax imposed, affects the cost of production of the price setters, burden can be shifted to the consumers, if the demand for the product is inelastic. However, if the imposition of tax affects the cost of production of only small firms, it cannot be easily shifted to the consumers.

Here the small firms are bound to follow the price determined by the price leaders. Hence small firms have to bear the tax burden. But the process of shifting in its ultimate analysis will be determined by the elasticities of demand and supply of taxed commodity.

(d) Shifting Under Different Cost Conditions:

Commodities can be produced under decreasing, increasing or con­stant cost conditions. The nature of the cost condition also influences the shifting of a tax.

(i) Decreasing cost condition:

If costs are decreasing, any decline in demand and consequent reduction in output will increase cost per unit. If under this condition, a tax is imposed on the producer and the producer attempting to shift the burden by raising the price, the demand for his product will decline and the cost per unit will rise. In that case, price will have to be raised by more than the amount of the tax, to cover increase in cost resulting from output restriction.

(ii) Increasing Cost:

If costs are increasing, a decline in output will lower cost per unit. A tax imposed under this condition, will raise the price of the commodity by an amount less than the amount of tax. As such, only a part of the tax burden will be shifted to the buyers.

This happen because imposition of a tax, will reduce the demand for the taxed commodity. Consequently, supply will have to be reduced. This reduction in supply leads to lower average cost.

(iii) Constant cost:

If a tax is shifted under constant cost conditions, price will rise exactly by the amount of the tax. However, fall in output will vary according to the nature of demand. The supply curve under constant cost condition will be perfectly elastic and as such price will rise to the full amount of the tax. In this situa­tion, entire burden will fall on consumers.

The demand and supply theory of tax shifting is abstract and is entirely based on deductive reasoning. Observations and experimen­tation were never used to approve or disapprove the theory.

The theory ignores the effect of government expenditure. Public expenditure is an important macroeconomic variable affecting the shifting of tax. However, the effects of government expenditure are complicated and very difficult to measure.

Moreover, the demand and supply theory of tax shifting consti­tute only a part of the general theory of value. The modern industrial productive sector is a combination of competitive and monopolistic practices.

Moreover, government function has embraced different economic spheres. Government’s role in development activities of the economy, provision of public goods, price control and other regu­latory measures do affect the working of the price system.

A com­prehensive theory of shifting alone can take into consideration, all these factors influencing the economy. Hence the demand and sup­ply theory cannot be considered as full-fledged incidence theory.

The theory also does not take into consideration the indirect money burden arising from the imposition of a tax. For a balanced analysis of the effect of tax, both direct and indirect money burden should be taken into consideration.

In this sense, the theory is one sided. Shifting power depend upon strength of bargaining power of sellers and buyers. The theory has given insufficient weightage to the strategic factor like bargaining power.

A theory of tax shifting cannot be considered comprehensive and complete unless the above said factors are duly considered in the analysis. In spite of these limitations, the demand and supply theory of incidence is the best available tool to analyses the inci­dence problem in taxation.