Tax Incidence

Definition

Tax incidence refers to the distribution of the burden or impact of a tax between the buyer and the seller in a market. It determines who ultimately pays the tax, the consumer or the producer, based on the relative price elasticities of demand and supply.

5 Must Know Facts For Your Next Test

1. The party that bears the greater portion of the tax burden is determined by the relative price elasticities of demand and supply.
2. If demand is more elastic than supply, the tax burden falls more heavily on the producer, and vice versa.
3. In a perfectly inelastic market, the entire tax burden falls on the consumer, regardless of who the tax is imposed on.
4. Taxes can create deadweight loss, reducing the total surplus in the market and leading to an inefficient allocation of resources.
5. The incidence of a tax can be shifted through changes in market conditions, such as the introduction of a substitute good or a change in the number of producers.

Review Questions

• Explain how the price elasticity of demand and supply influence the incidence of a tax.
  • The incidence of a tax, or who ultimately bears the burden of the tax, is determined by the relative price elasticities of demand and supply. If demand is more elastic than supply, the tax burden will fall more heavily on the producer, as they will be less able to pass the tax on to consumers. Conversely, if supply is more elastic than demand, the tax burden will fall more heavily on the consumer, as producers can more easily shift the tax onto them. In a perfectly inelastic market, the entire tax burden falls on the consumer, regardless of who the tax is imposed on.
• Describe how the introduction of a substitute good can affect the incidence of a tax.
  • The introduction of a substitute good can shift the incidence of a tax. If a substitute good becomes available, the demand for the original good becomes more elastic, as consumers have the option to switch to the substitute. This means that producers of the original good will be less able to pass the tax on to consumers, and the tax burden will fall more heavily on the producers. Conversely, if the substitute good is not readily available, the demand for the original good becomes more inelastic, and the tax burden will shift more towards the consumers.
• Analyze how changes in the number of producers in a market can impact the incidence of a tax.
  • The number of producers in a market can also influence the incidence of a tax. If there are many producers in a market, the supply curve is more elastic, as individual producers are less able to pass the tax on to consumers. In this case, the tax burden will fall more heavily on the producers. Conversely, if there are few producers in a market, the supply curve is more inelastic, and the tax burden will shift more towards the consumers. The degree of competition in a market is a key factor in determining the incidence of a tax, as it affects the ability of producers to pass the tax on to consumers.

Related terms

Price Elasticity of Demand:

The measure of how responsive the quantity demanded of a good or service is to a change in its price, all else equal.

Price Elasticity of Supply:

The measure of how responsive the quantity supplied of a good or service is to a change in its price, all else equal.

Deadweight Loss:

The loss in total surplus (consumer surplus plus producer surplus) that results from the imposition of a tax or other market distortion.