Incidence of Tax

29/04/2021 0 By indiafreenotes

Tax incidence (or incidence of tax) is an economic term for understanding the division of a tax burden between stakeholders, such as buyers and sellers or producers and consumers. Tax incidence can also be related to the price elasticity of supply and demand. When supply is more elastic than demand, the tax burden falls on the buyers. If demand is more elastic than supply, producers will bear the cost of the tax.

The tax incidence depicts the distribution of the tax obligations, which must be covered by the buyer and seller. The level at which each party participates in covering the obligation shifts based on the associated price elasticity of the product or service in question as well as how the product or service is currently affected by the principles of supply and demand.

Tax incidence reveals which group consumers or producers will pay the price of a new tax. For example, the demand for prescription drugs is relatively inelastic. Despite changes in cost, its market will remain relatively constant.

  • Tax incidence is the manner in which the tax burden is divided between buyers and sellers.
  • The tax incidence depends on the relative price elasticity of supply and demand. When supply is more elastic than demand, buyers bear most of the tax burden. When demand is more elastic than supply, producers bear most of the cost of the tax.
  • Tax revenue is larger the more inelastic the demand and supply are.

Price Elasticity and Tax Incidence

Price elasticity is a representation of how buyer activity changes in response to movements in the price of a good or service. In situations where the buyer is likely to continue purchasing a good or service regardless of a price change, the demand is said to be inelastic. When the price of the good or service profoundly impacts the level of demand, the demand is considered highly elastic.

Examples of inelastic goods or services can include gasoline and prescription medicines. The level of consumption across the economy remains steady with price changes. Elastic products are those whose demand is significantly affected by price. This group of products includes luxury goods, houses, and clothing.

The formula for determining the consumer’s tax burden with “E” representing elasticity is as follows:

  • E (supply) / (E (demand)) + E (supply)

The formula for determining the producer or supplier’s tax burden with “E” representing elasticity is as follows:

E (demand) / (E (demand) + E (supply))

Incidence of Tax

The incidence of tax refers to the ultimate economic burden or impact of a tax, determining who bears the actual cost of the tax. In any tax system, there are two main concepts related to tax incidence:

  1. Legal Incidence:

Legal incidence refers to the entity or individual legally responsible for remitting the tax to the government. This is the party identified by tax laws as being liable to pay the tax.

  1. Economic Incidence:

Economic incidence refers to the actual burden of the tax, indicating who ultimately bears the cost of the tax in economic terms. This may or may not be the same as the legally designated taxpayer.

Tax Incidence Examples:

  1. Direct Taxes:
    • Legal Incidence: For direct taxes like income tax, the legal incidence usually falls on individuals or entities with specific types of income.
    • Economic Incidence: The economic incidence depends on factors like the elasticity of demand for the taxed goods or services. For example, if a business faces a highly elastic demand for its products, it may pass on the tax burden to consumers in the form of higher prices, thus shifting the economic incidence to consumers.
  2. Indirect Taxes:
    • Legal Incidence: For indirect taxes like the Goods and Services Tax (GST), the legal incidence is on the businesses involved in the production and distribution of goods and services.
    • Economic Incidence: The economic incidence can vary. In some cases, businesses may pass on the tax burden to consumers through higher prices. However, businesses may absorb the tax if the market conditions are competitive and demand is sensitive to price changes.
  3. Corporate Taxes:
    • Legal Incidence: Corporations are legally responsible for paying corporate income taxes.
    • Economic Incidence: The economic incidence can be distributed among various stakeholders, including shareholders (in the form of reduced dividends or stock value), employees (in the form of lower wages), and consumers (in the form of higher prices).

Factors Influencing Tax Incidence:

  • Elasticity of Demand:

In markets with inelastic demand, businesses are more likely to pass on the tax burden to consumers through higher prices. In contrast, in markets with elastic demand, businesses may absorb the tax to remain competitive.

  • Elasticity of Supply:

In markets where the supply of goods or services is elastic, producers can more easily adjust production levels in response to changes in taxes without significant impact on prices.

  • Market Structure:

The degree of competition in a market influences the ability of businesses to pass on the tax burden. In competitive markets, businesses may have limited pricing power, affecting their ability to shift the tax burden to consumers.

  • Ability to Substitute:

If consumers can easily substitute one product for another, businesses may find it challenging to pass on the tax burden, as consumers can switch to alternatives with lower prices.

  • Bargaining Power:

The relative bargaining power of different economic agents, such as employers and employees or buyers and sellers, can influence how the economic burden of taxes is distributed.