incidence of taxation

Incidence of taxationclick for a larger image
Fig. 87 Incidence of taxation.

incidence of taxation

the location of the ultimate bearer (i.e. payer) of a TAX. For example, in the case of personal INCOME TAX, it is the individual taxpayer concerned who bears the tax. In other cases, due account must be taken of shifts in tax. For example, suppose the tax authorities impose a PAYROLL TAX on firms who treat the tax as an increase in their input costs and put up their prices by an equivalent amount. Then, assuming there is no fall in sales, it is the buyers of the firms’ products who bear the full burden of the tax, not the firms themselves.

The incidence of an INDIRECT TAX (such as EXCISE DUTY or VALUE-ADDED TAX) generally depends upon the PRICE-ELASTICITY OF DEMAND (and supply) of the products being taxed, with producers bearing most of the burden of the tax where demand is elastic and buyers bearing most of the burden of the tax where demand is inelastic. Fig. 87 contrasts the two situations.

In Fig. 87 (a), the imposition of an indirect tax equal to BE1 shifts the supply curve vertically upwards from S to S 1 . The effect of the tax is to increase equilibrium price from OP to OP1 and reduce equilibrium quantity from OQ to OQ1.Where product demand is price-elastic, as in Fig. 87 (a), the price increase is small and the reduction in quantity sold is large, with producers bearing most of the burden of the tax in lost sales and reduced profit margins. By contrast, where product demand is price-inelastic, as in Fig. 87 (b), the price increase is large and the reduction in quantity sold is small, with buyers bearing most of the burden of the tax in the form of a higher price. The relative burden of the tax borne by consumers is CE1 and that borne by producers is BC in both (a) and (b).

In choosing which products to levy indirect taxes upon, governments usually select products such as cigarettes and alcohol, demand for which is highly price-inelastic, in order to ensure that buyers bear the burden of the tax and that the effects upon suppliers and employment are minimized. See TAXATION, VALUE-ADDED TAX, PRINCIPLES OF TAXATION, LUMP SUM TAXES.