Incidence of Tax

Tax incidence meaning

We are now ready to finally cover the meaning of tax incidence. We know that the tax is charged per unit of output sold. The government can levy the tax on either the producer or the consumer. But we will see that the imposition of tax creates certain distortions in the market.Because of these distortions to market equilibrium, the tax may not actually be paid exclusively by one party as the government intended. The extent to which a party pays a portion of the tax burden is what tax incidence measures.

Impact and Incidence of Tax

The impacts of a tax incidence depend on many factors. The tax can be initially levied on the producer or the consumer. The demand or supply can be relatively elastic or inelastic. Let's take a closer look at two of the possibilities in turn:

1. When the tax is levied on a producer
2. When the tax is levied on the consumer

Incidence of tax: a tax levied on the producer

When a tax is levied on a producer, the supply curve will shift leftward. The price level for each quantity will be higher by the amount of tax. The equilibrium quantity will decrease, with consumers paying the higher price and suppliers receiving a lower price due to them paying the tax. The tax burden is shared by the consumer and producer. In other words, the tax is partially paid for by the consumer and partially by the producer. We can then say that the tax incidence for a producer can be measured by the decrease in the price they receive after the imposition of tax.

Let's take a look at Figure 1 below to visualize it better.

Fig. 1 - A tax levied on the producer

Figure 1 above shows a tax imposed on a seller. This shifts the supply curve leftward from S₀ to S_tax. Price P₀ and quantity Q₀ correspond to the initial equilibrium. After the tax, the price level is higher for each quantity by the amount of tax, which is equal to the vertical distance between the supply curves. The quantity decreases from Q₀ to Q_tax.

Officially, the producer pays the tax, but actually, the consumer shares in paying the tax as well. The consumer burden area represented in purple shows how much in total consumers share in paying the tax. They now pay a higher price - P_tax compared to P₀, while the producer receives P₁ after paying the government the tax. They receive (P₀-P₁) less per unit than the amount they would receive previously. In this example, the consumer and producer burdens are equal, but this may not necessarily always be the case.

Incidence of tax: a tax levied on the consumer

If the government taxes a consumer instead of a producer, the demand curve will shift leftward. Because the consumers are now paying the tax on their purchases, the final price will correspond to the old demand curve. Therefore the price level for each quantity will be higher by the amount of tax. Equilibrium quantity will fall, and consumers will be faced with higher prices. Suppliers, again, will receive a lower actual price corresponding to the new equilibrium price. The tax burden will once again be shared by the consumer and producer. The consumer tax incidence can be measured by an increase in the price that results from the imposition of tax.

Because we are economists, let's analyze this case with a diagram! Take a look at Figure 2 below.

Fig. 2 - A tax levied on the consumerFigure 2 above depicts a tax imposed on a consumer. Price P₀ and quantity Q₀ correspond to the initial equilibrium. The tax shifts the demand curve leftward from D₀ to D_tax. The price level is now higher for each quantity by the amount of tax, which is equal to the vertical distance between the demand curves. The quantity decreases from Q₀ to Q_tax. The producer burden area in yellow shows how much in total producers share in paying the tax. Consumers now pay a higher price - P_tax compared to P₀, while the producer receives P₁. They receive (P₀-P₁) less per unit than the amount they would receive previously. Again, the consumer and producer burdens are equal here, but they don't always have to be.

Tax incidence analysis

Having seen the tax incidence outcomes in cases when the tax is levied on a producer and consumer, we are now ready to turn to tax incidence analysis. The producer and consumer burden may be equally shared between the two parties. However, it doesn't always have to be the case.The extent of the burden shared by the consumer and the producer depends on the relative price elasticities of demand and supply. Let's summarize the effects of taxes on the producer and consumer for all the cases of demand and supply elasticities.If demand is relatively more price elastic than supply, the producers will bear more tax burden. Let's take a look at Figure 3 below.

Fig. 3 - Tax incidence when demand is more elastic than supply

Figure 3 above shows an example of a tax imposed on the producer. Because the demand is more price elastic than supply, the quantity demanded drops significantly (from Q₀ to Q_tax) compared to the price increase (from P₀ to P_tax). However, for the producer, the price drops significantly (from P₀ to P₁) compared to the quantity decrease. This results in the producer burden, represented by the yellow area, being more prominent than the consumer burden, represented by the purple area.If demand is relatively less price elastic than supply, the consumers will bear more tax burden. Let's observe this in Figure 4 below.

Fig. 4 - Tax incidence when supply is more elastic than demand

Figure 4 above shows an example of a tax imposed on the producer. Because the demand is less price elastic than supply, the quantity demanded drops slightly (from Q₀ to Q_tax) compared to the price increase (from P₀ to P_tax). On the other hand, the price the producer receives drops insignificantly (from P₀ to P₁) compared to a decrease in the quantity. This results in the consumer burden, represented by the purple area, being more significant than the producer burden, represented by the yellow area.The key takeaway is that the tax incidence does not depend on who officially pays the tax to the government.

Example of Tax Incidence

Let's take a look at some numerical examples of tax incidence. We can take each of the two cases in turn:

1. Tax levied on the producer
2. Tax levied on the consumer

Example of tax incidence: a tax levied on the producer

Imagine a tax levied on the sale of sugary drinks. The initial price is $5.00, and the quantity demanded is 90 units. A surcharge of $0.30 per bottle is imposed on the producer. The new price of drinks is $5.10 per bottle, and the new quantity demanded is 80 units. After the producers pay the tax to the government, they are left with $4.80 per unit sold. This scenario is illustrated in Figure 5 below.

Fig. 5 - Example of a tax levied on the producer

In the example above, the producer bears more tax burden than the consumer.

Example of tax incidence: a tax levied on the consumer

Imagine a tax levied on the consumption of cigarettes. The initial price is $5.00, and the quantity demanded is 50 units. A surcharge of $0.50 per pack is imposed on the consumer. The new price of cigarettes is $5.30 per pack, and the quantity demanded is now 40 units. After the consumers pay the tax to the government, producers are left with $4.80 per unit sold. This scenario is illustrated in Figure 6 below.

Fig. 6 - Example of a tax levied on the consumer

In the example above, the consumer bears more tax burden than the producer.