What is a tax incidence?

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The government imposes taxes on every product or service sold in the market. But who should pay for this tax? The buyer, the seller, or both? This is where the tax incidence comes in – the economic analysis determining how the tax burden is distributed between producers and consumers.

Here, we’ll explore tax incidence, how it works, and the factors that influence it.


Key insights

A tax incidence is how the tax burden is divided between buyers and sellers.

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A tax incidence analyzes who pays a new tax between consumers and producers.

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The elastic demand for goods is the main determinant of who bears a tax burden.

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How a tax incidence works

As mentioned, tax incidence is the economic analysis of how tax burden is divided between producers and consumers. It determines whose real income is reduced when a tax is imposed and by what degree.

When a product is taxed, the burden falls on consumers and producers. Economists analyze the supply and demand elasticity to determine which party pays most of the tax. The tax burden will have a higher impact on the inelastic side of supply and demand.

If the demand for a product is more inelastic than the supply (meaning the buyer’s consumption level isn’t affected by price change), the consumers will pay most of the tax. Inversely, if the supply is more inelastic than the demand (meaning, the supplier has to produce the same quantity regardless of the price change), the burden will fall more on sellers or producers. Elastic goods typically are products that are consumer necessities, whereas inelastic goods are nonessentials or products that could be substituted at a lower price.

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Statutory burden vs. actual burden

We've established that tax incidence is a fancy way of asking, "Who bears the tax burden?" It's important to note that who "bears" and who "pays" are rarely the same individual.

  • Statutory burden (or incidence) is the legal assignment of the tax. It describes the party responsible for remitting the tax to the government.
  • The actual burden or the economic incidence describes the party that bears the tax burden, whose money or resources are affected by the tax.

"In the U.S. economy, a clear example can be found in the tariffs imposed on imported goods,” says Taylor Kovar, founder of 11 Financial in Lufkin, Texas.

“Let's say the government decides to put a 25% tariff on imported steel. On paper, it looks like foreign steel producers are the ones being taxed. However, the real story often unfolds differently. The tax incidence can shift to U.S. companies that buy steel to make their products, like cars or appliances.”

These companies could eventually pass the cost onto consumers through higher prices. “So, while the tariff is technically on the foreign producers, the financial burden might end up on American consumers and businesses that use steel," Kovar says.

» MORE: What is excise tax?

Factors influencing tax incidence

We’ve seen how the elasticity of demand and supply is one of the main determinants of tax incidence. However, other factors, such as market structure and the nature of the tax imposed, can also influence tax incidence.

Elasticity and tax incidence

Elasticity measures the sensitivity of quantity supply and demand to changes in price. Here are the most common scenarios of that impact.

Elastic supply and inelastic demand

Inelastic demand means the consumer purchases the same quantity of a product regardless of the price change. The producer can maintain the production volume by increasing the price by the amount of tax imposed.

In this case, the tax burden falls on the consumer.

Inelastic supply and elastic demand

Inelastic supply means the customer is very sensitive to price changes. To maintain demand, the supplier must continue producing the same volume despite the extra cost.

Since a price change can cause a significant drop in the quantity demanded, the supplier bears the tax burden.

Similar elastic supply and demand

In this situation, consumers and producers are perfectly elastic and inelastic. The parties, therefore, share the tax burden.

If one party is more elastic than the other, they pay the greater portion of the tax.

Market structure

Market structure, such as competition levels, can influence tax incidence. In a perfect market, consumers and producers have no market power and they share the tax burden. This isn't the case with monopoly power or limited competition; sellers have more power to pass the tax burden to buyers.

For example, if a tax is imposed on a monopoly utility company, it can confidently increase the prices without fear of a drop in demand. In this case, the tax burden will likely fall on the consumer.

Nature of tax

If the government increases corporate taxes on capital or payroll or levies any other tax that affects factors of production, the supply curve shifts to the left. This means the supply quantity reduces, causing prices to rise because a tax increase doesn't affect the demand curve.

It also doesn't make supply or demand more or less elastic. This potential tax increase is a marginal tax, as it adds to existing taxes. This can negatively affect the income distribution in the economy.

» MORE: Buyer's market vs. seller's market: What's the difference?

Tax incidence and economic policy

Economists and policymakers need to understand tax incidence and the factors that influence it. By analyzing factors that affect tax burden division, policymakers can gain insights into how imposing taxes impacts the welfare of its citizens.

Making informed tax policies can ensure that products such as prescriptions and medical treatments are fairly taxed. It can also help avoid implications for income distribution that can snowball and affect the welfare of citizens at large. For example, high sales taxes affect the consumer's purchasing power and the retailer's sales, which could lead to store closings or job cuts.

Analyzing tax incidence can also help policymakers devise ways to regulate monopoly companies, preventing them from abusing their power.

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FAQ

What is an example of tax incidence?

When the government imposes a tax on cigarettes, the tax burden is transferred to consumers since a price change doesn't affect the demand. The increased cost buyers incur (tax burden) is an example of a tax incidence.

What does tax incidence determine?

It determines who bears the cost of a tax imposition on any economic transaction.

What is elastic versus inelastic demand?

Elastic demand is when the quantity demanded is significantly affected by price changes, while inelastic demand is when price changes have little or no effect on the amount demanded.

Bottom line

Tax incidence is an analysis that helps determine whose resources (mostly money) are used to pay taxes in an economic transaction. Who the tax burden falls on is subject to the willingness of the buyer to purchase the product with price changes.

Understanding tax incidence is important to ensure tax fairness and maintain the community's welfare. Inequitable tax policies can lead to health hazards, job cuts and businesses closing down, resulting in a sluggish economy.


Article sources

ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:

  1. Tax Foundation, “Tax Incidence.” Accessed March 25, 2024.
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