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.
- The consumer burden of a tax increase reflects the amount by which the market price rises.
- The producer burden is the decline in revenue firms face after paying the tax.
Example of tax incidence
In the diagram on the left, demand is price inelastic. A tax of £6 causes the price to rise from £10 to £14.
- The consumer burden is 80 x £4 = £320
- The producer burden is £10-£8 = £2 x 80 = £160
The diagram on the right, demand is price elastic. There is only a small rise in price and a bigger percentage fall in demand.
- The consumer burden is 50 x £1 = £50
- The producer burden is 50 x (13-8) = £250
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 x 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.
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.
Demand for cigarettes is very price inelastic. An increase in excise duties leads to nearly 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 a 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 on how inelastic demand for the workers is. 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.