70 Tax Incidence
Learning Objectives
- Explain how the price elasticities of demand and supply determine the incidence of a tax on buyers and sellers
Elasticity and Tax Incidence
People often assume that when government imposes a tax on purchases of some product, producers simply raise the price of the product so that consumers end up paying the tax. Makes sense, right? Except like many economic myths, it’s not true. The analysis, or manner, of how a tax burden is divided between consumers and producers is called tax incidence. Tax incidence depends on the price elasticities of supply and demand.
The example of cigarette taxes introduced previously demonstrated that because demand is inelastic, taxes are not effective at reducing the equilibrium quantity of smoking, and they mainly pass along to consumers in the form of higher prices. With other products, however, the burden of the tax can be very different. Let’s drill down into these ideas.
Watch It
This video introduces the idea of the tax burden and demonstrates how taxes impact both consumers and producers. Look closely at the graphs towards the end of the video to graphically see how different elasticities cause the tax incidence to shift. When the demand is inelastic, consumers pay more of the tax, but when demand is elastic, the burden falls on the producers.
Typically, the tax incidence, or burden, falls both on the consumers and producers of the taxed good. However, if one wants to predict which group will bear most of the burden, all one needs to do is examine the elasticity of demand and supply. In the tobacco example, the tax burden falls on the most inelastic side of the market.
Note also, that when taxes on sales affect the equilibrium quantity, there are effects on economic welfare. You can see that as reductions in consumer surplus, reductions in producer surplus and deadweight loss. The size of these changes depends on the price elasticities of demand and supply.
Let’s consider another example. Imagine a $1 tax on every barrel of apples that an apple farmer produces. If the product (apples) is price inelastic to the consumer then the farmer is able to pass the entire tax on to consumers of apples by raising the price by $1. In this situation, consumers bear the entire burden of the tax, or 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, the farmer has to bear the burden of the tax through decreased revenues, therefore 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. If demand is more inelastic than supply, consumers bear most of the tax burden, and if supply is more inelastic than demand, sellers bear most of the tax burden.
The intuition for this is simple. When the demand is inelastic, consumers are not very responsive to price changes, and the quantity demanded reduces only