Tax incidence is a measure of who ultimately pays a tax, either directly or through the tax burden. This burden can be split between buyers and consumers, or different groups in the economy.
Elasticity and Tax Incidence
Elasticity measures the relationship between price and demand of goods. If the demand for a good changes significantly with a change in price, then a good is elastic—likely a non-necessity like a new car or home goods. Little to no change in demand in relation to price means a good is inelastic, and consumers will continue to purchase the good as prices go up. Examples of inelastic goods include gasoline and prescription drugs.
Taxes on inelastic goods like cigarettes shift the tax incidence to the consumer who will continue to purchase the product, despite the price increase from the tax. Conversely, if a tax is levied on an elastic good, the tax incidence falls on the producer because the new price increase is likely to reduce the demand for the good.
For example, an increase in the general sales tax may lead shoppers to spend less on retail goods like clothing, resulting in less revenue for a shop. This decline in revenue can then cost jobs or even cause a store to close its location, because clothing is an elastic good that consumers can forgo if the price is deemed too high. In the end, the tax incidence from the higher sales tax falls on the business.
Legal Incidence vs. Economic Incidence
There are two forms of tax incidence. Legal incidence is who required by law to pay the tax, whereas economic incidence is the burden of the tax felt in economic factors like prices, wages, or returns to shareholders.
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 is generally very different from the final economic burden. Because taxes influence the relative prices facing individuals, they lead to changes in individual 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 society.
Once tax-induced changes in behavior throughout the economy are accounted for, the final distribution of the economic burden of taxes is called the economic incidence. It is also referred to as the tax burden faced by individuals in their roles as consumers, workers, and investors.
For example, the legal incidence of corporate income taxes typically falls on companies, but the economic incidence of the tax is shifted forward to others, in the form of higher prices for consumers, lower wages for workers, reduced returns to shareholders, or some combination of the three.
Tax collections represent legal incidence only, whereas tax burdens measure the economic incidence of taxes.
Stay updated on the latest educational resources.
Level-up your tax knowledge with free educational resources—primers, glossary terms, videos, and more—delivered monthly.
Subscribe