Incidence of a Tax, Elasticity and Tax Incidence, Graph, Formula
Tax incidence definition
What is tax incidence?
The incidence of a tax (tax incidence) explains how the tax burden is divided between the parties such as consumers and producers. By discussing the incidence of a tax, we can understand how tax impact the different groups in society.
Taxation means the compulsory levies are imposed by the government on business organizations and individuals. Most countries in the world impose taxes on the people. Taxation can be identified as the major source of income for many governments. Beyond the imposition of taxes, the government receives non-tax income such as dividends income, interest income, and so on.
The effect of a tax on buyers and sellers depends on demand elasticity and supply elasticity. Sellers bear a smaller incidence of a tax when supply is more elastic than demand. Buyers bear a smaller incidence of a tax when demand is more elastic than supply.
Elasticity and tax incidence
What is elasticity?
Elasticity describes how a variable is changed as a result of the changes in another variable. In economics, mostly the term elasticity is used to measure the degree of changes in the quantity supplied and the quantity of demanded as a result of the changes in the supply and demand determinants. As examples for the supply determinants, we can say the price of a particular good, prices of related goods, technology, input prices, future expectations of the suppliers, and so on. As examples for the supply determinants, we can say the price of a particular good, prices of related goods, income level of the consumers, consumer preferences and so on.
Types of elasticity.
According to economists, there are different types of the elasticities. Usually in economics, these elasticities are related to the demand and supply of a particular good. So, we can identify two major types of elasticities. They are,
- Elasticity of demand
- Elasticity of supply
But within these two major types of elasticities, we can identify the most useful and famous subtypes of elasticities. I will explain to them as follows.
Price elasticity of demand
Price elasticity of demand means the percent of change in the quantity of demand as a result of the change in the price of the particular good.
You may be interested into read more,
How to Calculate Price Elasticity of Demand?
Cross-price elasticity of demand
The cross-price elasticity of demand means the percent of change in the quantity of demand for a good as a result of the change in the price of the substitute or complementary good.
You may be interested into read more,
Cross Price Elasticity of Demand Meaning, Formula & Calculations
Income elasticity of demand
Income elasticity of demand means the percent of change in the quantity of demand for a particular good as a result of the change in the income level of the consumers.
Price elasticity of supply
Price elasticity of supply means the percent of change in the quantity of supply as a result of the change in the price of the particular good.
You may be interested into read more,
Price Elasticity of Supply Meaning, Formula & Examples
Relationship between elasticity and tax incidence
There is a strong relationship between the value of elasticity and incidence of tax. when a good is taxed, the burden of the tax (incidence of a tax) is not only bearing one party. Tax incidence can be divided in both sellers and buyers.
Who bears the burden of tax?
It is very important to find how the tax burden is divided between customers and producers. Normally when government imposes a tax on a good or service, both the consumer and supplier have to bear the cost of the tax.
If you want to predict whether consumers or producers bear the higher portion of the tax burden, you have to examine the demand and supply elasticities of the particular good.
In other words, the effect of a tax on buyers and sellers depends on demand elasticity and supply elasticity. Sellers bear a smaller incidence of a tax when supply is more elastic than demand. Buyers bear a smaller incidence of a tax when demand is more elastic than supply.
How do demand elasticity and supply elasticity influence the incidence of a tax?
1. Demand is more inelastic than supply
Inelastic demand means situation customers are less responsive toward price changes. Although the price is increasing or decreasing, consumers tend to remain the quantity of demand constant. The tax burden on consumers is high when demand is more inelastic than supply
Tax incidence examples
When we consider products such as insulin, cigarette, and so on, we can see an inelastic demand situation.
People who take insulin medicine cannot decrease the demand when the price is increasing since insulin is essential to survive their lives. But the governments are less interested in imposing taxes on medicine such as insulin.
People who consume cigarette also shows an inelastic demand. Because they are addicted to the product. The governments impose higher levels of taxes on cigarettes as stated by the SEATCA Tobacco Tax Program. The tobacco tax percentage based on the retail price is 58.6% (SEATCA Tobacco Tax Program, 2021). Government can earn a higher income by implementing a tax on cigarettes. Because consumers who are addicted to cigarettes do not decrease the demand by a significant amount although the price has increased. Consumer incidence of tax is high. In other words, when we consider effect of tax on buyers and sellers, the tax burden on consumers (buyers) is very high.
The following tax incidence diagram will clearly show the tax implementation on cigarettes.
Tax incidence diagram – tax implementation on cigarettes
According to the above tax incidence diagram, the demand curve of cigarettes in USA is more inelastic than the supply curve of cigarettes. Before the USA government imposes taxes on cigarettes, the equilibrium price is P1, and the equilibrium quantity is Q1.
Assume that after the government imposes a tax on cigarettes as a result of it, the supply curve has been shifted leftward (Shifted from S to S + Tax). Now market equilibrium price has been increased to P2 and the market equilibrium quantity has been decreased to Q2. As a result of the tax implementation, the equilibrium quantity has decreased from a small portion. Because demand is very inelastic. Market price has increased from a higher portion.
Who bears the burden of tax?
Consumers bear a higher tax burden (as mentioned in the red-coloured area) while suppliers bear a lower tax burden (as mentioned in the green-coloured area). In other words, the tax burden on consumers is high and tax burden on sellers is low.
How to calculate tax revenue from graph?
The total tax revenue that government can collect is equal to the red coloured area plus the green coloured area.
2. Supply is more inelastic than demand
Inelastic supply means situation suppliers are less responsive toward price changes. Although the price is increasing or decreasing, suppliers tend to remain the quantity of supply constant. The tax burden on sellers is high when supply is more inelastic than demand.
Tax incidence examples
When we consider products such as beach hotels, apartments, and so on, we can see an inelastic supply situation.
When the government implements a tax on beach hotels, suppliers cannot decrease the number of beach hotels in the short run. So, suppliers have to bear a larger portion of taxes. Because suppliers cannot pass a large portion of taxes to the consumers. If suppliers could decrease the supply of beach hotels, they could bear only a small portion of the taxes and pass a higher burden to the consumers.
The scenario of the apartments is also the same as the above scenario of the beach hotels. Government can earn a higher income by implementing a tax on apartments.
The following tax burden (incidence) diagram will clearly show the tax implementation on apartments.
Tax burden diagram – tax implementation on apartments
According to the above tax burden graph, the demand curve of apartments in USA is more elastic than the supply curve of apartments. Before the USA government imposes taxes on apartments, the equilibrium price is P1, and the equilibrium quantity is Q1.
Assume that after the government imposes a tax on apartments and as a result of it, the supply curve has been shifted leftward (Shifted from S to S + Tax). Now market equilibrium price has been increased to P2 and the market equilibrium quantity has been decreased to Q2. As results of the tax implementation, the market price has increased from a smaller portion.
Who bears the burden of tax?
Producer bear a higher tax burden (as mentioned in the green coloured area) while consumer bear a lower tax burden (as mentioned in the red coloured area). In other words, the tax burden on sellers (producers) is high and tax burden on buyers (consumers) is low.
How to calculate tax revenue from graph?
The total tax revenue that government can collect is equal to red coloured area plus green coloured area.
Demand and supply elasticity is same
Beyond the above cases, sometimes the elasticity of demand and elasticity of supply for a particular good can be equal to each other. If the government imposes a tax on such kind of good, the supplier and consumer have to bear an equal tax burden. In other words, the total tax burden is divided equally between supplier and consumer.
How to calculate tax incidence?
The effect of a tax on buyers and sellers depends on demand elasticity and supply elasticity. Sellers bear a smaller incidence of a tax when supply is more elastic than demand. Buyers bear a smaller incidence of a tax when demand is more elastic than supply.
Tocalculate tax incidence that each party bear, we can apply tax incidence formula
Tax incidence formula
Formular for consumer incidence of tax
Consumer tax burden = Es/ (Es – Ed)
Formular supplier incidence of tax
Supplier tax burden = -Ed/ (Es – Ed)
Example – How to calculate tax burden on buyers and sellers?
Assume that the government implements a tax on a particular good. Unit per tax is $10. Price elasticity of demand is -0.2 and price elasticity of supply is 1.2. Calculate tax burden on buyers (consumers) and sellers (suppliers)
Consumer tax burden = Es/ (Es – Ed)
= 1.2/ (1.2 – -0.2) = 1.2/ 1.4 = 0.8571 or 85.71%
Consumer incidence of tax / Tax burden on consumers = 10x 85.71% = $8.571
Supplier tax burden = -Ed/ (Es – Ed)
= – -0.2/ (1.2 – -0.2)
=0.2/ 1.4
= 0.1429 or 14.29%
Supplier incidence of tax/ tax burden on suppliers = 10x 14.29%= $1.429
