Tax incidence

U.S. federal effective tax rates by income percentile and component as projected for 2014 by the Tax Policy Center.^[1][2]

Taxation
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By country List of countries by tax rates Tax revenues as %GDP Albania Algeria Argentina Australia Azerbaijan Bangladesh Bhutan Bulgaria Canada China Colombia France Germany Greece Iceland India Indonesia Iran Ireland Israel Italy Japan Kazakhstan Lithuania Malta Namibia Netherlands New Zealand Norway Pakistan Palestinian territories Peru Philippines Poland Russia Singapore South Africa Sweden Switzerland Tanzania United Kingdom United States Uruguay

In economics, tax incidence or tax burden is the analysis of the effect of a particular tax on the distribution of economic welfare. Tax incidence is said to "fall" upon the group that ultimately bears the burden of, or ultimately has to pay, the tax. The key concept 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. The concept was brought to attention by the French Physiocrats and in particular François Quesnay who argued that the incidence of all taxation falls ultimately on landowners and is at the expense of land rent. For this reason they advocated the replacement of the multiplicity of contemporary taxes by the Impôt Unique, which is similar to what would later be known by Georgists as a 'Single-Tax' on land value. A leading advocate of this tax was Turgot. Physiocrats were correct in their analysis of the tax incidence of land value tax, that it benefits society and falls entirely on landlords. However, they were incorrect in believing that the entire incidence of those indirect taxes would fall on landowners. Even though the incidence of taxes on activities such as consumer sales or employment will lower land values indirectly, maybe by even more than the value of the original tax, some excess burden is likely to also fall on consumers and producers.

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 is bearing 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 the incidence of the tax falls on the employer, since there is a "floor" to wages set by factors such as the level of unemployment or welfare benefit. This follows logically from Ricardo's Law of Rent.

Example of tax incidence

Imagine a $1 tax on every barrel of apples an apple farmer produces. If the product (apples) is price inelastic to the consumer the farmer is able to pass the entire tax on to consumers of apples by raising the price by $1. In this example, consumers bear the entire burden of the tax; the tax incidence falls on consumers. On the other hand, if the apple farmer is unable to raise prices because the product is price elastic the farmer has to bear the burden of the tax or face decreased revenues: the tax incidence falls on the farmer. If the apple farmer can raise prices by an amount less than $1, then consumers and the farmer are sharing the tax burden. When the tax incidence falls on the farmer, this burden will typically flow back to owners of the relevant factors of production, including agricultural land and employee wages.

Where the tax incidence falls depends (in the short run) on the price elasticity of demand and price elasticity of supply. Tax incidence falls mostly upon the group that responds least to price (the group that has the most inelastic price-quantity curve). If the demand curve is inelastic relative to the supply curve the tax will be disproportionately borne by the buyer rather than the seller. If the demand curve is elastic relative to the supply curve, the tax will be born disproportionately by the seller. If PED = PES the tax burden is split equally between buyer and seller.

Tax incidence can be calculated using the pass-through fraction. The pass-through fraction for buyers is PES/(PES - PED). So if PED for apples is -0.4 and PES is 0.5 then the pass-through fraction to buyer would be calculated as follows: PES/(PES - PED) = 0.5/[0.5 - (-.0.4)] = 0.5/0.9 = 56%. 56% of any tax increase would be "paid" by the buyer; 44% would be "paid" by the seller. From the perspective of the seller, the formula is -PED/(PES - PED) = -(-0.4)/[0.5 -(-0.4)] = 0.4∕.9 = 44%

Graphical analysis

Inelastic supply, elastic demand

Because the producer is inelastic, they will produce the same quantity no matter what the price. Because the consumer is elastic, the consumer is very sensitive to price. A small increase in price leads to a large drop in the quantity demanded. The imposition of the tax causes the market price to increase from P without tax to P with tax and the quantity demanded to fall from Q without tax to Q with tax. Because the consumer is elastic, the quantity change is significant. Because the producer is inelastic, the price doesn't change much. The producer is unable to pass the tax onto the consumer and the tax incidence falls on the producer. In this example, the tax is collected from the producer and the producer bears the tax burden. This is known as back shifting. Tax incidence or burden does not in any way depend on where the revenue has been collected. It rather depends on the price elasticity of demand as well as the price elasticity of the supply. Tax burden as seen refers to the people who pay the taxes whether producer or consumer and considers the societal effects that result. It is said to fall entirely on the group that bears the burden or who has to pay the tax. If a producer becomes inelastic, he will continue producing the same quantity no matter the price that they incur. In case the consumer is elastic; the consumer becomes very sensitive and weary of the price (Melville 24). A small increase in the price of something leads to a large drop in the quantity that is being demanded. The imposition of taxes causes the market price to have an increase from P without taxes. It rises to P with taxes. In most markets, elasticities of the supply and demand are similar to the short-run and result in the burden of the taxes that has been imposed. The tax that has been imposed is shared between two groups and in varying proportions. In general, the group that will have a greater tax burden is the one that exhibits greater relative inelasticity (Prasad 49). When there is an increase in elasticity in one place, the demand for the quantity changes so that it can suit the different needs that have been set by the tax burden. Tax burden, therefore, varies a lot with elasticity in materials.

Similarly elastic supply and demand

Most markets fall between these two extremes, and ultimately the incidence of tax is shared between producers and consumers in varying proportions. In this example, the consumers pay more than the producers, but not all of the tax. The area paid by consumers is obvious as the change in equilibrium price (between P without tax and P with tax); the remainder, being the difference between the new price and the cost of production at that quantity, is paid by the producers.

Inelastic supply, elastic demand: the burden is on producers

Similar elasticities: burden shared

Macroeconomic perspective

The supply and demand for a good is deeply intertwined with the markets for the factors of production and for alternate goods and services that might be produced or consumed. Although legislators might be seeking to tax the apple industry, in reality it could turn out to be truck drivers who are hardest hit, if apple companies shift toward shipping by rail in response to their new cost. Or perhaps orange manufacturers will be the group most affected, if consumers decide to forgo oranges to maintain their previous level of apples at the now higher price. Ultimately, the burden of the tax falls on people—the owners, customers, or workers.^[4]

However, the true burden of the tax cannot be properly assessed without knowing the use of the tax revenues. If the tax proceeds are employed in a manner that benefits owners more than producers and consumers then the burden of the tax will fall on producers and consumers. If the proceeds of the tax are used in a way that benefits producers and consumers, then owners suffer the tax burden. These are class distinctions concerning the distribution of costs and are not addressed in current tax incidence models. The US military offers major benefit to owners who produce offshore. Yet the tax levy to support this effort falls primarily on American producers and consumers. Corporations simply move out of the tax jurisdiction but still receive the property rights enforcement that is the mainstay of their income.

Other considerations of tax burden

Consider a 7% import tax applied equally to all imports (oil, autos, hula hoops, and brake rotors; steel, grain, everything) and a direct refund of every penny of collected revenue in the form of a direct egalitarian "Citizen's Dividend" to every person who files Income Tax returns. At the macro level (aggregate) the people as a whole will break even. But the people who consume foreign produced goods will bear more of the burden than the people who consume a mix of goods. The people who consume no foreign goods will bear none of the burden and actually receive an increase in utility. On the producer side, the tax burden distribution will depend on whether a firm produces its goods within the sovereignty or outside the sovereignty. Firms that produce goods inside the sovereignty will increase their market share and their profits when compared to firms who offshore their production. And if the current mix of firms is tilted toward offshore production then the owners of firms will be burdened more than the consumers while the workers/employees will benefit from greater employment opportunities.^[5]

Tax burden of a country relative to GDP

A country or state's tax burden as a percentage of GDP is the ratio of tax collection against the national gross domestic product (GDP). This is one way of illustrating how high and broad the tax base is in any particular place. Some countries, like Sweden, have a high tax-to-GDP ratio (as high as 54%). Other countries, like India, have a low ratio. Some states increase the tax-to-GDP ratio by a certain percentage in order to cover deficiencies in the state budget revenue. In states where the tax revenue has gone up significantly, the percentage of tax revenue that is applied towards state revenue and foreign debt is sometimes higher. When tax revenues grow at a slower rate than the GDP of a country, the tax-to-GDP ratio drops. Taxes paid by individuals and corporations often account for the majority of tax receipts, especially in developed countries.^[6]

Clarification

The burden from taxation is not just the quantity of tax paid (directly or indirectly), but the magnitude of the lost consumer surplus or producer surplus. The concepts are related but different. For example, imposing a $1000 per gallon of milk tax will raise no revenue (because legal milk production will stop), but this tax will cause substantial economic harm (lost consumer surplus and lost producer surplus). When examining tax incidence, it is the lost consumer and producer surplus that is important. See the tax article for more discussion.

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.

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.^[7]

The empirical evidence tends 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.^[8]

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.^[9][10] This does not prove causation. It is possible that the time of higher economic growth provided government with more leeway to impose higher taxes.

See also

• Effect of taxes and subsidies on price
• Excess burden of taxation
• Externalities and Pigovian taxes
• Fiscal incidence
• Flypaper theory of tax incidence
• Optimal tax
• List of countries by tax revenue as percentage of GDP

Notes