Tax Incidence

Tax incidence is the analysis of who really pays a tax once prices, wages and profits have adjusted to it. The person or firm that hands the money to the tax authority carries the statutory (legal) incidence. The people whose real income falls because of the tax carry the economic incidence, and the two are often different. A fuel duty collected from refiners can end up mostly in the pump price paid by drivers; a payroll charge levied on employers can end up mostly in lower pay for workers.

Incidence sits at the centre of public finance. Governments use it to judge whether a tax is fair, whether it is progressive or regressive in practice, and how a change in the tax system will ripple through markets. It is closely tied to the idea of elasticity: whoever can adjust their behaviour more easily tends to escape more of the burden.

Picture a ferry that charges each passenger a new harbour fee. The ferry company writes the cheque to the port, but whether the company or the passengers end up worse off depends on who has other options. If there is a bridge nearby, the company cannot raise fares much without losing riders, so it swallows most of the fee. If the ferry is the only way across, passengers simply pay more.

Tax incidence asks that same question for every tax. The name on the tax form tells you who does the paperwork, not who loses money. The side of the market with fewer alternatives, the one that is "stuck", usually ends up carrying the larger share.

A basic result in supply and demand analysis is that, in a competitive market, it makes no difference to the final outcome whether a tax is legally charged to the buyer or the seller. Either way the tax opens a gap between the price buyers pay and the price sellers keep, and the market settles at the same quantity. What decides the split is the relative responsiveness of the two sides. When demand is inelastic, as with cigarettes, basic food or petrol in the short run, consumers bear most of a tax. When supply is inelastic, as with land, producers or owners bear most of it. The same reasoning applies to indirect taxes such as a sales tax or value-added tax and to direct taxes on income and profits.

For a small per-unit tax in a competitive market, the share of the burden passed on to buyers is approximately:

• $\varepsilon_s$ is the price elasticity of supply, the percentage change in quantity supplied for a 1% change in price.
• $\varepsilon_d$ is the price elasticity of demand, which is negative; $|\varepsilon_d|$ is its absolute value.
• The sellers' share is one minus the buyers' share.

Suppose a government adds a tax of $1.00 per unit. Supply elasticity is 2 and demand elasticity is −0.5. The buyers' share is 2 ÷ (2 + 0.5) = 0.8, so the price paid by consumers rises by about 80 cents and the price received by sellers falls by about 20 cents. If the elasticities were reversed, the split would flip to 20 cents for buyers and 80 cents for sellers. The tax also shrinks the quantity traded, and the trades that no longer happen create an efficiency cost known as deadweight loss, which grows with the square of the tax rate.

• Payroll and social insurance taxes. In the United States, Social Security tax is split equally between employer and employee by law. Most empirical studies find that workers bear most or all of the employer's half through lower wages, because labor supply is relatively inelastic.
• Corporate income tax. Arnold Harberger's 1962 model showed that a tax on corporate profits spreads to all owners of capital. In open economies, where capital can move abroad, part of the burden shifts to workers through lower investment and pay. The US Congressional Budget Office and Joint Committee on Taxation assign about 75% of the corporate tax to owners of capital and 25% to labor; other researchers argue labor's share is higher.
• Consumption taxes. VAT and sales taxes are usually passed largely to consumers. Because poorer households spend a larger share of income, these taxes look regressive when measured against annual income, though less so against lifetime income.
• Taxes on land and property. Since the supply of land is fixed, a tax on land value falls on owners and is capitalized into lower land prices, an argument used by supporters of land-value taxation.

Incidence analysis shapes most tax debates. Distribution tables published by finance ministries and budget offices rely on incidence assumptions, so different assumptions can make the same reform look progressive or regressive. Incidence also matters for corrective taxes: a carbon tax or other Pigouvian tax changes behaviour only if prices rise for the polluting activity, which means someone must bear the cost. In open economies incidence is linked to tax competition, because mobile capital can avoid a high tax by moving, leaving immobile factors such as labor and land to bear more. Debates over the Laffer curve and supply-side economics also turn on how strongly taxpayers respond to rates.

The simple formula assumes competitive markets, small taxes and fixed elasticities. Under monopoly, or when firms set prices with some market power, pass-through can exceed 100% of the tax. Short-run and long-run incidence often differ, because supply becomes more elastic as firms enter, exit or relocate. General-equilibrium effects, where a tax in one market shifts prices in others, are hard to measure, and estimates for the corporate tax in particular vary widely between studies.

• U.S. Department of the Treasury: Office of Tax Analysis
• Office for National Statistics: Effects of taxes and benefits on household income