Tax incidence is a measure of who bears the legal or economic burden of a tax. Legal incidence identifies who is responsible for paying a tax while economic incidence identifies who bears the cost of tax—in the form of higher prices for consumers, lower wages for workers, or lower returns for shareholders.
Legal Incidence vs. Economic Incidence
Any time a tax is paid, there are two concepts at work. First, there is the requirement to pay. Second, there is the economic effect. These two concepts make up legal and economic incidence.
Think of a store that must collect and pay sales tax on products it sells. The store makes regular tax payments to the relevant authority, but it is common knowledge that the person actually bearing the higher cost of the tax is the customer. The customer pays the store extra money to compensate for the sales tax payment that the store will eventually send to the government.
The legal incidence of taxes falls on those who are legally required to submit tax payments to state and local governments. Legal incidence is established by law and tells us which individuals or companies must physically send tax payments to state and local treasuries.
The legal incidence of taxes can be different from the final economic burden since economic incidence is the burden of the tax felt by consumers (like the customer in the store).
Economic incidence can also impact wages or returns to shareholders in certain circumstances. Think of a business that must pay corporate taxes on its profits. That money comes from the business’s profits, which are earned through its workers providing services or products to customers using the technology and equipment the business owns. The business also has shareholders who provide the financial capital for the business, and they expect a return on their investment.
When the business pays taxes, it is compelled to spend money on something other than its workers’ wages, additional machinery or technology, or payouts to shareholders. Even though the business is legally required to pay the taxes, the money comes from somewhere else. If the business pays its workers less than it otherwise would in order to pay the tax bill, then the economic incidence of the tax falls on the workers.
If the firm pays a lower dividend to shareholders because of the tax, then the economic incidence falls on its shareholders. The shareholders and workers both bear a part of the economic incidence if the company invests less than it otherwise would in order to pay the tax.
The business could also increase prices on its products to generate resources to pay the tax. This would shift the incidence of the tax to consumers.
Because taxes influence the prices that individuals face, they lead to changes in behavior. Tax-induced changes in behavior cause some portion (or all) of the economic incidence of taxes to be shifted from those bearing the legal incidence onto others in the economy.
Identifying Economic Incidence
Economic incidence is sometimes easy to identify. If a sales tax applies to a product a person buys, then the customer generally bears the economic incidence. If a tax applies to payroll, then the workers will see less in their paychecks. In both cases, companies legally pay the tax, but they don’t feel the economic burden of it.
However, it is not always that simple. Different taxes have different economic incidence depending on the structure of the tax and the flexibility that a taxpayer has to set wages, prices, or investment plans.
For example, if a company is in a very competitive market for a product, but, because of its location or some other specific factor, it faces a tax that its competitors do not, then it will likely not be able to raise the price of its products in the face of the tax. If it were to raise prices, its customers could choose to go to a different store where the special tax does not apply. Instead, it may reduce payouts to shareholders, adjust investment plans, or reduce wages for workers.
If the company in the example did raise prices, then the reduction in customers would also end up impacting some combination of the company’s workers and shareholders.
If, instead of the example above, all companies faced a higher tax, then they might choose to increase prices, reduce wages or investment, or limit returns to shareholders.
Customers bear the economic incidence of taxes on goods with stable demand like food, clothing, fuel, alcohol, and cigarettes. Purchases of these products are not usually sensitive to price, and consumers are not able to pass the cost of the tax on to anyone else. However, if a tax is placed on something like a luxury product, then purchases of that product may fall in response to the tax and the economic incidence would fall on the firms selling those products.
Further Reading
Don Fullerton and Gilbert E. Metcalf, “Tax Incidence,” NBER Working Paper No. 8829, March 2002, https://www.nber.org/papers/w8829.
Stefanie Stantcheva, “Lecture 3: Tax Incidence and Efficiency Costs of Taxation,” Harvard University, 2017, https://scholar.harvard.edu/files/stantcheva/files/lecture3.pdf.
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