Tax incidence

Tax incidence

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In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, tax incidence is the analysis of the effect of a particular tax
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...

 on the distribution of economic welfare
Welfare economics
Welfare economics is a branch of economics that uses microeconomic techniques to evaluate economic well-being, especially relative to competitive general equilibrium within an economy as to economic efficiency and the resulting income distribution associated with it...

. Tax incidence is said to "fall" upon the group that, at the end of the day, bears the burden of the tax. The key concept is that the tax incidence or tax burden does not depend on where the revenue is collected, but on the price elasticity of demand
Price elasticity of demand
Price elasticity of demand is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price...

 and price elasticity of supply
Price elasticity of supply
Price elasticity of supply is a measure used in economics to show the responsiveness, or elasticity, of the quantity supplied of a good or service to a change in its price....

. The concept was brought to attention by the French Physiocrats and in particular François Quesnay
François Quesnay
François Quesnay was a French economist of the Physiocratic school. He is known for publishing the "Tableau économique" in 1758, which provided the foundations of the ideas of the Physiocrats...

 who argued that the incidence of all taxation falls ultimately on landowners and is at the expense of land rent. For this reason they advocated the replacement of the multiplicity of contemporary taxes by the Single Tax, or Impôt Unique. A leading advocate of this tax was Turgot.
In the first instance, however, the incidence of the tax falls elsewhere. For example, a tax on apple farmers might actually be paid by owners of agricultural land but the incidence may initially fall on consumers of apples.

Initially, the incidence of all labour related taxes such as income tax and NI contributions falls on employers. This must be so at the margin since the employee must receive more net of tax ie take-home than they can receive from the alternative, such as welfare benefit payments. The tax surcharge may be as high as 80%.

In that all business taxes reduce profitability, and in accordance with the principles set out by the Physiocrats, they reduce the amount of rent that the business can pay and thus the incidence falls on the landowner. The land owner may be the business itself but the effect is to cut into that part of the revenue stream that consists of land rental value. A secondary effect is that locations with low land values become sub-marginal when taxes are imposed. That is, viable economic activity would be non-existent.

This is a plausible explanation for the problem of marginality and regional maldistribution of business which affects most economies. There will always be margins but the tax system has a significant influence. The exception to this principle is a tax levied only on the rental value of land, as proposed by the Physiocrats. In that case no tax is payable at the margin, where land has no value.

The theory of tax incidence has a number of practical results. For example, United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...

 Social Security
Social Security (United States)
In the United States, Social Security refers to the federal Old-Age, Survivors, and Disability Insurance program.The original Social Security Act and the current version of the Act, as amended encompass several social welfare and social insurance programs...

 payroll taxes are paid half by the employee and half by the employer. However, some economists think that the worker is bearing almost the entire burden of the tax because the employer passes the tax on in the form of lower wages. The tax incidence is thus said to fall on the employee. However, this view is in direct contradiction to that put forward by the Physiocrats.

Example of tax incidence


Imagine a $1 tax on every barrel of apples an apple farmer produces. If the product (apples) is price inelastic to the consumer (whereby if price rose, a small demand loss would be accounted for by the extra revenue), the farmer is able to pass the entire tax on to consumers of apples by raising the price by $1. In this example, consumers bear the entire burden of the tax; the tax incidence falls on consumers. On the other hand, if the apple farmer is unable to raise prices because the product is price elastic (if prices rose, more demand would be lost than extra revenue gained), the farmer has to bear the burden of the tax or face decreased revenues: the tax incidence falls on the farmer. If the apple farmer can raise prices by an amount less than $1, then consumers and the farmer are sharing the tax burden. When the tax incidence falls on the farmer, this burden will typically flow back to owners of the relevant factors of production
Factors of production
In economics, factors of production means inputs and finished goods means output. Input determines the quantity of output i.e. output depends upon input. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function...

, including agricultural land and employee wages.

Where the tax incidence falls depends (in the short run) on the price elasticity of demand
Price elasticity of demand
Price elasticity of demand is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price...

 and price elasticity of supply
Price elasticity of supply
Price elasticity of supply is a measure used in economics to show the responsiveness, or elasticity, of the quantity supplied of a good or service to a change in its price....

. Tax incidence falls mostly upon the group that responds least to price (the group that has the most inelastic price-quantity curve). If the demand curve is inelastic relative to the supply curve the tax will be disproportionately borne by the buyer rather than the seller. If the demand curve is elastic relative to the supply curve, the tax will be born disproportionately by the seller. If PED = PES the tax burden is split equally between buyer and seller.

Tax incidence can be calculated using the pass-through fraction. The pass-through fraction for buyers is PES/(PES - PED). So if PED for apples is -0.4 and PES is 0.5 then the pass-through fraction to buyer would be calculated as follows: PES/PES - PED = 0.5/[0.5 - (-.0.4)] = 0.5/0.9 = 56%. 56% of any tax increase would be "paid" by the buyer; 44% would be "paid" by the seller. From the perspective of the seller, the formula is -PED/(PES - PED) = -(-0.4)/[0.5 -(-0.4)] = 0.4∕.9 = 44%

Graphical analysis

For a primer on reading supply and demand graphs, see: Supply and Demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

.
For a primer on the economic effects of a tax, see: Tax
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...

.

Inelastic supply, elastic demand



Because the producer is inelastic, he will produce the same quantity no matter what the price. Because the consumer is elastic, the consumer is very sensitive to price. A small increase in price leads to a large drop in the quantity demanded. The imposition of the tax causes the market price to increase from P without tax to P with tax and the quantity demanded to fall from Q without tax to Q with tax. Because the consumer is elastic, the quantity change is significant. Because the producer is inelastic, the price doesn't change much. The producer is unable to pass the tax onto the consumer and the tax incidence falls on the producer. In this example, the tax is collected from the producer and the producer bears the tax burden. This is known as back shifting.

Inelastic demand, elastic supply


Because the consumer is inelastic, he will demand the same quantity no matter what the price. Because the producer is elastic, the producer is very sensitive to price. A small drop in price leads to a large drop in the quantity produced. The imposition of the tax causes the market price to increase from P without tax to P with tax and the quantity demanded to fall from Q without tax to Q with tax. Because the consumer is inelastic, the quantity doesn't change much. Because the consumer is inelastic and the producer is elastic, the price changes dramatically. The change in price is very large. The producer is able to pass (in the short run) almost the entire value of the tax onto the consumer. Even though the tax is being collected from the producer the consumer is bearing the tax burden. The tax incidence is falling on the consumer, known as forward shifting.

Similarly-elastic supply and demand


Most markets fall between these two extremes, and ultimately the incidence of tax is shared between producers and consumers in varying proportions. In this example, the consumers pay more than the producers, but not all of the tax. The area paid by consumers is obvious as the change in equilibrium price (between P without tax toP with tax); the remainder, being the difference between the new price and the cost of production at that quantity, is paid by the producers.

Macroeconomic perspective


The supply and demand for a good is deeply intertwined with the markets for the factors of production and for alternate goods and services that might be produced or consumed. Although legislators might be seeking to tax the apple industry, in reality it could turn out to be truck drivers who are hardest hit, if apple companies shift toward shipping by rail in response to their new cost. Or perhaps orange manufacturers will be the group most affected, if consumers decide to forgo oranges to maintain their previous level of apples at the now higher price. Ultimately, the burden of the tax falls on people—the owners, customers, or workers.

However, the true burden of the tax cannot be properly assessed without knowing the use of the tax revenues. If the tax proceeds are employed in a manner that benefits owners more than producers and consumers then the burden of the tax will fall on producers and consumers. If the proceeds of the tax are used in a way that benefits producers and consumers, then owners suffer the tax burden. These are class distinctions concerning the distribution of costs and are not addressed in current tax incidence models. The US military offers major benefit to owners who produce offshore. Yet the tax levy to support this effort falls primarily on American producers and consumers. Corporations simply move out of the tax jurisdiction but still receive the property rights enforcement that is the mainstay of their income.

Other Considerations of Tax Burden


Consider a 7% import tax applied equally to all imports (oil, autos, hula hoops, and brake rotors; steel, grain, everything) and a direct refund of every penny of collected revenue in the form of a direct egalitarian "Citizen's Dividend" to every person who files Income Tax returns. At the macro level (aggregate) the people as a whole will break even. But the people who consume foreign produced goods will bear more of the burden than the people who consume a mix of goods. The people who consume no foreign goods will bear none of the burden and actually receive an increase in utility. On the producer side, the tax burden distribution will depend on whether a firm produces its goods within the sovereignty or outside the sovereignty. Firms that produce goods inside the sovereignty will increase their market share and their profits when compared to firms who offshore their production. And if the current mix of firms is tilted toward offshore production then the owners of firms will be burdened more than the consumers while the workers/employees will benefit from greater employment opportunity.

Clarification


The burden from taxation is not just the quantity of tax paid (directly or indirectly), but the magnitude of the lost consumer surplus or producer surplus. The concepts are related but different. For example, imposing a $1000 per gallon of milk tax will raise no revenue (because legal milk production will stop), but this tax will cause substantial economic harm (lost consumer surplus and lost producer surplus). When examining tax incidence, it is the lost consumer and producer surplus that is important. See the tax
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...

 article for more discussion.

Other practical results


The theory of tax incidence has a large number of practical results, although economists dispute the magnitude and significance of these results:
  • Because businesses are more sensitive to wages than employees, payroll taxes, employer mandates, and other taxes collected from the employer end up being borne by the employee. The tax is passed onto the employee in the form of lower wages.
  • If the government requires employers to provide employees with health care, some of the burden will fall on the employee as the employer will pass it on in the form of lower wages. Some of the burden will be borne by employer (and ultimately the customer in form of higher prices or lower quality) since both the supply of and demand for labor are highly inelastic and have few perfect substitutes. Employers need employees largely to the extent they can substitute employees for machines, and employees need employers largely to the extent they can become self-employed entrepreneurs. An uneducated population is therefore more susceptible to bearing the burden because they are more easily replaced by machines able to do unskilled work, and because they have less knowledge of how to make money on their own.
  • Taxes on easily substitutable goods
    Substitute good
    In economics, one way we classify goods is by examining the relationship of the demand schedules when the price of one good changes. This relationship between demand schedules leads economists to classify goods as either substitutes or complements. Substitute goods are goods which, as a result...

    , such as oranges and tangerine
    Tangerine
    __notoc__The tangerine is an orange-colored citrus fruit which is closely related to the Mandarin orange . Taxonomically, it should probably be formally named as a subspecies or variety of Citrus reticulata; further work seems to be required to ascertain its correct scientific name...

    s, may be borne mostly by the producer because the demand curve for easily substitutable goods is quite elastic.
  • Similarly, taxes on a business that can easily be relocated are likely be borne almost entirely by the residents of the taxing jurisdiction and not the owners of the business.
  • The burden of tariff
    Tariff
    A tariff may be either tax on imports or exports , or a list or schedule of prices for such things as rail service, bus routes, and electrical usage ....

    s (import taxes) on imported vehicles might fall largely on the producers of the cars because the demand curve for foreign cars might be elastic if car consumers may substitute a domestic car purchase for a foreign car purchase.
  • If consumers drive the same number of miles regardless of gas prices, then a tax on gasoline will be paid for by consumers and not oil companies (this is assuming that the price elasticity of supply of oil is high, which is incorrect. In this case both the price elasticity of demand and supply are very low). Who actually bears the economic burden of the tax is not affected by whether government collects the tax at the pump or directly from oil companies.

Assessment


Assessing tax incidence is a major economics subfield within the field of public finance
Public finance
Public finance is the revenue and expenditure of public authoritiesThe purview of public finance is considered to be threefold: governmental effects on efficient allocation of resources, distribution of income, and macroeconomic stabilization.-Overview:The proper role of government provides a...

.

Most public finance economists acknowledge that nominal tax incidence (i.e. who writes the check to pay a tax) is not necessarily identical to actual economic burden of the tax, but disagree greatly among themselves on the extent to which market forces disturb the nominal tax incidence of various types of taxes in various circumstances.

The effects of certain kinds of taxes, for example, the property tax, including their economic incidence, efficiency properties and distributional implications, have been the subject of a long and contentious debate among economists.

The empirical evidence tends support different economic models under different circumstances. For example, empirical evidence on property tax incidents tends to support one economic model, known as the "benefit tax" view in suburb
Suburb
The word suburb mostly refers to a residential area, either existing as part of a city or as a separate residential community within commuting distance of a city . Some suburbs have a degree of administrative autonomy, and most have lower population density than inner city neighborhoods...

an areas, while tending to support another economic model, known as the "capital tax" view in urban and rural areas.

There is an inherent conflict in any model between considering many factors, which complicates the model and makes it hard to apply, and using a simple model, which may limit the circumstances in which its predictions are empirically useful.

See also

  • Effect of taxes and subsidies on price
    Effect of taxes and subsidies on price
    Taxes and subsidies change the price of goods and, as a result, the quantity consumed.- Tax impact :A marginal tax on the sellers of a good will shift the supply curve to the left until the vertical distance between the two supply curves is equal to the per unit tax; when other things remain equal,...

  • Public finance
    Public finance
    Public finance is the revenue and expenditure of public authoritiesThe purview of public finance is considered to be threefold: governmental effects on efficient allocation of resources, distribution of income, and macroeconomic stabilization.-Overview:The proper role of government provides a...

  • Fiscal incidence
    Fiscal incidence
    Fiscal incidence is a concept within public finance, a sub-discipline within economics, that refers to the combined overall economic impact of both government taxation and expenditures on the real economic income of individuals. While taxation reduces the economic well-being of individuals,...

  • Flypaper theory (economics)
    Flypaper theory (economics)
    The flypaper theory of tax incidence is a pejorative term used by economists to describe the assumption that the burden of a tax, like a fly with flypaper, sticks wherever it first lands...

     of tax incidence
  • Fiscal neutrality
  • Tax policy
    Tax policy
    Tax policy is the government's approach to taxation, both from the practical and normative side of the question.-Philosophy:Policymakers debate the nature of the tax structure they plan to implement and how they might affect individuals and businesses .The reason for such foitution effect]],...