Tax incidence

Tax incidence refers to how the burden of a tax is distributed between firms and consumers (or between employer and employee). The tax incidence depends upon the relative elasticity of demand and supply.

For example, if demand is very price inelastic, then a higher tax will mostly be paid for by the consumer in the form of higher prices. If demand is price elastic, producers will absorb most of the tax increase in the form of lower profits.

Example of elastic demand

In this case the tax is £7. The tax reduces demand from 120 to 70.

The price rises from £20 to £21.

Consumer burden of tax

The consumer burden is the extra amount the consumers pay. This is an extra £1. The total consumer burden is the total amount of tax paid for by consumers.

Therefore, the consumer burden of the tax is £1 * 70 = £70

Producer burden of the tax

The producer burden of the tax is the lost revenue to the firm. Before the tax they used to get £20. After the tax is paid to the government, they are left with £14. They are £6 worse off.

The total producer burden is £6 * 70 = £420

In this case the total tax revenue = £7 * 70 = £490.

However, the tax incidence is mostly borne by the producer. The consumer only pays a small percentage.

Inelastic demand

Usually demand is more price inelastic.

In this case the tax is £12. The tax increases the market price from £17 to £25.

• The consumer burden is £8 *95 = £760
• The producer burden is £4* 95 = £380

In this case a higher percentage of the tax burden is borne by the consumer.

Cigarette tax

Often demand for goods is very price inelastic and an increase in excise duties leads to all the tax being passed onto the consumer.

For example, the UK has increased tax on tobacco, and this is reflected in a higher price of cigarettes.

National insurance contributions

In the case of tax on labour, the incidence of the tax could be borne by the employer and employee. If the employee has to pay N.I. contributions on employing labour, they may, at least partly, cut wages to be able to pay for the tax. It depends how inelastic demand for the workers are. If workers are easily replaceable by capital, the firm will be able to cut wages to pay the tax. But, if workers are essential, the firm will be more likely to pay the cost of the tax and not cut wages.

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2 thoughts on “Tax incidence”

1. ELASTIC DEMAND _A producer pays the tax burden
INELASTIC DEMAND_ A consumer pays the tax burded

2. I want the importance of tax incidence