Tax Incidence

Published Oct 26, 2023

Definition of Tax Incidence

Tax incidence refers to the distribution of the burden of a tax between buyers and sellers in a market. It analyzes who ultimately bears the economic cost of a tax, whether it is the buyers, the sellers, or a combination of both. The incidence of a tax depends on the price elasticity of demand and supply, as well as the relative bargaining power of buyers and sellers.

Example

Let’s consider the market for cigarettes. Suppose the government imposes a tax on each pack of cigarettes sold. Initially, the price of a pack is P₁ and the quantity demanded and supplied is Q₁. After the tax is implemented, the price paid by buyers will increase to P₂, while the price received by sellers will decrease to P₃. As a result, the quantity demanded decreases to Q₂, and the quantity supplied decreases to Q₃.

In this example, the incidence of the tax falls more heavily on the buyers than the sellers. Buyers now pay a higher price for the cigarettes, resulting in a decrease in quantity demanded. Sellers, on the other hand, receive a lower price for their cigarettes, reducing their profitability. However, the burden of the tax on sellers may be partially passed on to buyers through higher prices.

Why Tax Incidence Matters

Understanding tax incidence is crucial for policymakers, economists, and businesses. By analyzing the incidence of a tax, policymakers can evaluate the distributional effects of taxation and make informed decisions about tax rates and structures. It also helps economists predict how taxes affect market outcomes and economic efficiency.

For businesses, understanding tax incidence can provide insights into how taxes impact their costs and revenues. It can help them analyze the elasticity of demand and supply in their market and make strategic decisions to minimize the negative effects of taxation on their profitability.

Overall, tax incidence plays a vital role in shaping tax policy and understanding the economic effects of taxation.