“Tax incidence” refers to the assessment of how the burden of a tax is divided between stakeholders, such as buyers and sellers, or producers and consumers. This concept is also tied to the price elasticity of supply and demand. In scenarios where supply is more elastic than demand, buyers primarily shoulder the tax burden. However, if demand is more elastic than supply, producers will bear more of the tax cost.
Key Takeaways
- Tax incidence details how the burden of a tax is shared between industry stakeholders.
- It elucidates who will shoulder a tax—be it consumers, producers, or various population segments.
- The elasticity of a product’s demand elucidates the division of the tax burden.
How Tax Incidence Works
Tax incidence explains the division of tax responsibilities that must be absorbed by both buyers and sellers. This allocation is influenced by the product or service’s price elasticity as well as the overarching laws of supply and demand.
Example: The market for prescription drugs is generally inelastic. Therefore, changes in their cost don’t largely affect demand. This property fundamentally determines which participant—consumer or producer—bears the new tax imposed.
Implementing New Taxes on Inelastic and Elastic Goods
Cigarettes are often cited as an inelastic product. As such, an added cigarette tax results in producers simply increasing prices to transfer the tax burden to consumers. In practice, demand for cigarettes remains relatively stable following minor price hikes, adhering to inelastic behavior.
Conversely, increasing taxes on elastic goods such as fine jewelry offloads more burden onto producers because the demand for these goods significantly fluctuates with price changes. Thus, elastic goods, often having close substitutes or being luxury items, will see a steeper demand alteration when taxed.
Price Elasticity and Tax Incidence
Price elasticity gauges whether consumers will change their purchasing behavior in response to price adjustments in goods or services. If the consumption of a product remains consistent despite price changes, the demand is deemed inelastic. When price changes significantly alter purchase behavior, demand is highly elastic.
Some Inelastic Goods:
- Gasoline
- Prescription Medicines
Some Elastic Goods:
- Luxury Goods
- Houses
- Clothing
Finding Tax Burdens:
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Consumer’s tax burden is calculated as:
$$\text{E (Supply) / (E (Demand) + E (Supply))}$$
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Producer’s tax burden is calculated as:
$$\text{E (Demand) / (E (Demand) + E (Supply))}$$
The Determination of Tax Incidence
Tax incidence delineates the entity that ultimately endures the expense of a tax rather than just the entity that directly pays the tax.
Impact on Consumers versus Retailers
Various stakeholders can feel the heat from tax incidence. For example, consumers subjected to higher sales taxes would reduce their retail spending, potentially leading to decreased retailer revenue, job cuts, and even store closures.
Comparing Elastic and Inelastic Demand
Elastic demand varies with the product’s price, economic conditions, or consumer financial health. On the contrary, inelastic demand retains stability despite monetary changes, economic conditions, tax incidence, or other economic variables. This is observable when comparing optional purchases like entertainment with essential items, such as food and medicine.
Related Terms: elasticity, supply, demand, consumer economics, tax policy
