Tax Incidence

Tax Incidence: The manner in which the burden of a tax is distributed among economic units - consumers, producers, employees, employers, and so on. Or in other words, which party carries the actual burden of the tax.

The actual tax burden does not always fall on those who are statutorily assigned to pay the tax (the legal assignment is called the Statutory Incidence). So, who actually  bears the burden of the tax?  This depends on who is best able to change his or her behavior in response to the tax or who has the greater elasticity. Economic analysis indicates that the actual burden of a tax is independent of whether it is statutorily placed on the buyer or seller.

To see this, we will first look at how the market responds to a tax statutorily placed on the seller. To illustrate this concept, let's consider an example where the government places a $1,000 tax on the seller of a $7,000 used car and following that, the imposition of the same tax on buyers as well.

EXAMPLE

Suppose we are interested in purchasing a used car that is priced at $7,000 before taxes.

In our first scenario, a $1,000 tax is imposed statutorily on the seller of used cars. This would result in a vertical supply curve shift upward (to the left) by the amount of the tax. The price of the used car to buyers increases from $7000 to $7400, resulting in buyers bearing $400 of the burden of the tax. The actual amount kept by the seller falls from $7,000 to $6,400 ($7,400 minus the $1,000 tax). In this case, the seller carried $600 of the burden.

Likewise, a $1000 tax imposed statutorily on the buyer of a $7000 used car shifts that buyer's demand curve downward (to the right) by the amount of the tax. As a result of this, the price of the used car falls from $7000 to $6400 resulting in the seller bearing $600 of the burden. The buyer's total cost of purchasing the car rises from $7000 to $7400 ($6400 plus the $1000 tax), resulting in the buyer bearing $400 of the burden of the tax.

A comparison of the above illustrations make it clear that the actual burden of the $1000 tax is independent of its statutory incidence. In both cases, buyers pay a total price of $7400 for the car (a $400 increase from the pretax level), and the seller receive $6400 from the sale (a $600 decrease from the pretax level). The incidence of the tax on used cars is the same regardless of whether it is statutorily imposed on buyers or sellers.

Correspondingly, the revenues derived by the government, the number of sales eliminated by the tax, and the size of the dead-weight loss, also known as excess burden of taxation, are identical regardless of whether the law requires payment of the tax by sellers or by the buyers. 

Tax Incidence Applied to the United States

 

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