Tax Incidence

Tax incidence is the division of the real economic burden of a tax between buyers and sellers. It is measured by how much the price paid by buyers rises and how much the net price received by sellers falls after the tax creates a tax wedge between the two prices.

Central role of elasticity

The burden depends mainly on the relative price elasticities of demand and supply, not on whom the law formally requires to deposit the tax.

• When demand is relatively inelastic and supply is relatively elastic, buyers bear more because they reduce purchases only slightly when price rises.
• When supply is relatively inelastic and demand is relatively elastic, sellers bear more because they have less ability to withdraw supply.
• A perfectly inelastic side bears the entire burden, while a perfectly elastic side can avoid the burden by changing the quantity traded.
• The side with fewer practical alternatives is generally less responsive to price and therefore bears more of the tax.

How the burden is transmitted

A tax shifts the market equilibrium by raising the buyer's payment above the seller's net receipt. Statutory incidence identifies who remits the tax, while economic incidence identifies whose real income or purchasing power ultimately falls.

• Changing the legal obligation from seller to buyer does not, by itself, change the final burden when market conditions remain unchanged.
• Buyers bear tax through higher prices, while sellers bear it through lower net receipts and possibly reduced sales.
• The tax also reduces the quantity exchanged, creating an efficiency loss beyond the revenue transferred to government.

Other determinants and distributional significance

Actual incidence can also vary with market structure, the period considered, mobility of factors, availability of substitutes, and the geographical scope of the market.

• Long-run incidence may differ because consumers and producers usually have more time to adjust their behaviour.
• A tax may be regressive when lower-income households bear a larger burden relative to their income, especially for widely consumed necessities.
• Incidence analysis is therefore essential for assessing whether taxation supports revenue mobilisation without undermining inclusive growth.