# Tax incidence

In economics, tax incidence or tax burden is the effect of a particular tax on the distribution of economic welfare. Economists distinguish between the entities who ultimately bear the tax burden and those on whom tax is initially imposed. The tax burden measures the true economic weight of the tax, measured by the difference between real incomes or utilities before and after imposing the tax, taking into account how the tax leads prices to change. If a 10% tax is imposed on sellers of butter, for example, but the market price rises 8% as a result, most of the burden is on buyers, not sellers. The concept of tax incidence was initially brought to economists' attention by the French Physiocrats, in particular François Quesnay, who argued that the incidence of all taxation falls ultimately on landowners and is at the expense of land rent. Tax incidence is said to "fall" upon the group that ultimately bears the burden of, or ultimately suffers a loss from, the tax. The key concept of tax incidence (as opposed to the magnitude of the tax) is that the tax incidence or tax burden does not depend on where the revenue is collected, but on the price elasticity of demand and price elasticity of supply. As a general policy matter, the tax incidence should not violate the principles of a desirable tax system, especially fairness and transparency.[1] The concept of tax incidence is used in political science and sociology to analyze the level of resources extracted from each income social stratum in order to describe how the tax burden is distributed among social classes. That allows one to derive some inferences about the progressive nature of the tax system, according to principles of vertical equity.[2]

The theory of tax incidence has a number of practical results. For example, United States Social Security payroll taxes are paid half by the employee and half by the employer. However, some economists think that the worker bears almost the entire burden of the tax because the employer passes the tax on in the form of lower wages. The tax incidence is thus said to fall on the employee.[3] However, it could equally well be argued that in some cases the incidence of the tax falls on the employer. This is because both the price elasticity of demand and price elasticity of supply effect upon whom the incidence of the tax falls. Price controls such as the minimum wage which sets a price floor and market distortions such as subsidies or welfare payments also complicate the analysis.[citation needed]

## Tax incidence in competitive markets

Figure 1 – tax incidence in perfect competition

In competitive markets firms supply quantity of the product equals to the level at which the price of the good equals marginal cost (supply curve and marginal cost curve are indifferent). If an excise tax (a tax on the goods being sold) is imposed on producers of the particular good or service, the supply curve shifts to the left because of the increase of marginal cost. The tax size predicts the new level of quantity supplied, which is reduced in comparison to the initial level. In Figure 1 – a demand curve is added into this instance of competitive market. The demand curve and shifted supply curve create a new equilibrium, which is burdened by the tax.[4] The new equilibrium (with higher price and lower quantity than initial equilibrium) represents the price that consumers will pay for a given quantity of good extended by the part of the tax ${\displaystyle (p_{0}+kt),k\in [0,1].}$

The point on the initial supply curve with respect to quantity of the good after taxation represents the price (from which the part of the tax is subtracted ${\displaystyle (p_{0}-(1-k)t),k\in [0,1])}$ that producers will receive at given quantity. In this case, the tax burden is borne equally by the producers and consumers. For example, if the initial price of the good is $2, and the tax levied on the production is$.40, consumers will be able to buy the good for $2.20, while producers will receive$1.80.

Consider the case when the tax is levied on consumers. Unlike when tax is imposed on producers, the demand curve shifts to the left to create new equilibrium with initial supply (marginal cost) curve. The new equilibrium (at a lower price and lower quantity) represents the price that producers will receive after taxation and the point on the initial demand curve with respect to quantity of the good after taxation represents the price that consumers will pay due to the tax. Thus, it does not matter whether the tax is levied on consumers or producers.[5]

It also does not matter whether the tax is levied as a percentage of the price (say ad valorem tax) or as a fixed sum per unit (say specific tax). Both are graphically expressed as a shift of the demand curve to the left. While the demand curve moved by specific tax is parallel to the initial, the demand curve shifted by ad valorem tax is touching the initial, when the price is zero and deviating from it when the price is growing. However, in the market equilibrium both curves cross.[5]

Income taxes are taxes on the supply of labor (if the income is wages) or capital (if the income is dividends, for example). Corporate income tax incidence is difficult to evaluate because although the direct burden is on corporate shareholders, the tax tends to move capital to be supplied more to non-corporate uses such as housing or partnerships, reducing the return to capital generally, and it moves capital abroad, reducing wages. Thus, in the long-run, once the quantity of capital has adjusted, the incidence is likely on non-corporate capital as much as corporate capital, and much of it may be on labor. Economists' estimates of the incidence vary widely.[6]

## Effects on the budget constraint

Through the budget constraint might be seen, that uniform tax on wages and uniform tax on consumption have an equivalent impact. Both taxes shift the budget constraint to the left. New line will be characterized by same slope as the initial (parallelism).[5]

## Other practical results

The theory of tax incidence has a large number of practical results, although economists dispute the magnitude and significance of these results:

• If the government requires employers to provide employees with health care, some of the burden will fall on the employee as the employer will pass it on in the form of lower wages. Some of the burden will be borne by employer (and ultimately the customer in form of higher prices or lower quality) since both the supply of and demand for labor are highly inelastic and have few perfect substitutes. Employers need employees largely to the extent they can substitute employees for machines, and employees need employers largely to the extent they can become self-employed entrepreneurs. An uneducated population is therefore more susceptible to bearing the burden because they are more easily replaced by machines able to do unskilled work, and because they have less knowledge of how to make money on their own.
• Taxes on easily substitutable goods, such as oranges and tangerines, may be borne mostly by the producer because the demand curve for easily substitutable goods is quite elastic.
• Similarly, taxes on a business that can easily be relocated are likely to be borne almost entirely by the residents of the taxing jurisdiction and not the owners of the business.
• The burden of tariffs (import taxes) on imported vehicles might fall largely on the producers of the cars because the demand curve for foreign cars might be elastic if car consumers may substitute a domestic car purchase for a foreign car purchase.
• If consumers drive the same number of miles regardless of gas prices, then a tax on gasoline will be paid for by consumers and not oil companies (this is assuming that the price elasticity of supply of oil is high). Who actually bears the economic burden of the tax is not affected by whether government collects the tax at the pump or directly from oil companies.

## Tax burden analysis

Predominantly, studies of different distributions of the tax burden are carried out at a comparative level, either geographically (between different countries) or intertemporally (comparing distributions under different governments or regimes). The tax burden analysis aims to describe how different social classes contribute to the public sector.[2]

In the United States, the analysis regarding how the tax burden affects each of its social classes is conducted regularly. The Congressional Budget Office presents a series of reports showing the share of all federal taxes paid by taxpayers at the same point in the income distribution. Their data for 2017 shows the following:

• The top 1% of the distribution pay 25% of all federal taxes.
• The highest quintile pays 87% of all individual income taxes and 69% of all federal taxes.[13]

## Assessment

Assessing tax incidence is a major economics subfield within the field of public finance.

Most public finance economists acknowledge that nominal tax incidence (i.e. who writes the check to pay a tax) is not necessarily identical to actual economic burden of the tax, but disagree greatly among themselves on the extent to which market forces disturb the nominal tax incidence of various types of taxes in various circumstances.

The effects of certain kinds of taxes, for example, the property tax, including their economic incidence, efficiency properties and distributional implications, have been the subject of a long and contentious debate among economists.[14]

The empirical evidence tends to support different economic models under different circumstances. For example, empirical evidence on property tax incidents tends to support one economic model, known as the "benefit tax" view in suburban areas, while tending to support another economic model, known as the "capital tax" view in urban and rural areas.[15]

There is an inherent conflict in any model between considering many factors, which complicates the model and makes it hard to apply, and using a simple model, which may limit the circumstances in which its predictions are empirically useful.

Lower and higher taxes were tested in the United States from 1980 to 2010 and it was found that the periods of greatest economic growth occurred during periods of higher taxation.[16][17]

## Notes

1. ^ "Fairness".
2. ^ a b Pechman, Joseph A. (1985). Who paid the taxes, 1966-85?. Washington, D.C.: Brookings Institution. ISBN 0-8157-6998-9. OCLC 11495905.
3. ^ International Burdens of the Corporate Income Tax
4. ^
5. Stiglitz, J.E. (2000) Economics of the Public Sector, 3. Edition.
6. ^ Auerbach, Alan J. 2018. "Measuring the Effects of Corporate Tax Cuts." Journal of Economic Perspectives, 32(4):97-120. DOI: 10.1257/jep.32.4.97, p.99.
7. ^
8. ^
9. ^ a b Tresch, Richard W. (2014). Public Finance: A Normative Theory. Academic Press. ISBN 978-0-12-415834-4.
10. ^ Auerbach, A. J.; Feldstein, M. (2002). Handbook of Public Economics, Volume 4. North Holland. ISBN 9780080885919.CS1 maint: multiple names: authors list (link)
11. ^ "Forms of Taxation - Lawrance George
12. ^ "Tax-To-GDP Ratio"
13. ^ "The Distribution of Household Income, 2017 | Congressional Budget Office". www.cbo.gov. 2020-10-02. Retrieved 2021-04-30.
14. ^ See, e.g., Zodrow GR, Mieszkowski P. "The Incidence of the Property Tax. The Benefit View vs. the New View". In: Local Provision of Public Services: The Tiebout Model after Twenty-Five Years—Zodrow GR, ed. (1983) New York: Academic Press. 109–29.
15. ^ Zodrow, The Property Tax Incidence Debate and the Mix of State and Local Finance of Local Public Expenditures (2008), citing Fischel, Regulatory Takings: Law, Economics, and Politics (1995)
16. ^ LEONHARDT, DAVID (September 15, 2012). "Do Tax Cuts Lead to Economic Growth?". nytimes.com. The New York Times Company. Retrieved 16 April 2014.
17. ^ Blodget, Henry (21 September 2012). "BOMBSHELL: New Study Destroys Theory That Tax Cuts Spur Growth". www.businessinsider.com. Business Insider, Inc. Retrieved 16 April 2014.