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Definition:  Tax incidence is the distribution of the overall tax burden between sellers and buyers in an economy. In other words, it analyzes who is paying more of the overall taxes in the economy, the buyer or the seller.

What Does Tax Incidence Mean?

What is the definition of tax incidence?  The overall tax burden in an economy typically shifts between the buyers and sellers depending on the price elasticity of  demand and supply . If  demand is more elastic  than the economic supply, the tax burden will fall on the producer. Likewise if the elasticity of supply is greater than demand, more of the tax burden will fall on the buyers.

Let’s look at an example.

Example

When taxes are imposed on goods or services with relatively  inelastic demand  like medicine or medical care, suppliers are able to raise the price of the good or service by the tax amount because of the lack of significant change to  quantity demanded  when prices change. Thus, they are able to avoid paying any of the tax because it is passed on to the buyer.

In most cases, demand is not this inelastic and the entire tax burden cannot be passed on to consumers. Usually the elasticity is somewhere between elastic and inelastic. This means that the producer could potentially pass some of the expense on in the form of higher prices but not all of it. The remaining tax burden would be the producer’s responsibility.

Take pencils for example. A $0.25 tax on pencils could result in a $0.10 increase in price by producers. The producers would be responsible for the remaining $0.15 tax.

These tax burdens have far reaching effects, even for changes under a dollar. Cut backs made by producers can make their suppliers feel the impact through reduced use and purchase of required inputs.

The group that is least affect by price will bear the largest amount of the tax responsibility. To calculate the incidence of tax formula, you can use the pass-through method.

Price Elasticity of Supply (.5) / (Price Elasticity of Supply (.5) – Price Elasticity of Demand (-.04)) = 0.5 / [0.5 – (-.0.4)] = 0.5/0.9 = 56% is the amount paid by the buyer.

100% – 56% = 44% is the amount of tax incidence paid by the seller.

Summary Definition

Define Tax Incidence:  Incidence of tax means the shift of economic tax burden from buyer to sellers and vice versa due to changes in the elasticity of demand and supply.


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