Tax Shifting
Tax shifting refers to the process by which the burden of a tax is transferred from the party legally liable to pay it to another party, through changes in prices. The analysis of tax shifting, or tax incidence, determines who ultimately bears the cost of a tax, which may differ from the party on whom it is levied.
Mechanisms of Shifting
A tax can be shifted forward, to consumers, through an increase in the price of the taxed good. It can be shifted backward, to suppliers, through a reduction in the price paid for inputs. The extent of shifting depends on the elasticities of demand and supply in the markets affected.
For a tax on a good, the burden falls more heavily on the side of the market that is less elastic. If demand is inelastic and supply is elastic, consumers bear most of the tax. If demand is elastic and supply is inelastic, producers bear most of it.
Incidence and Elasticity
The analysis of incidence shows that the legal assignment of the tax is irrelevant to its economic effects. Whether a tax is levied on buyers or sellers, the outcome is the same, with the burden divided according to the elasticities. This result, known as the irrelevance of legal incidence, is a fundamental insight of tax analysis.
Elasticities in the long run may differ from those in the short run, affecting the incidence. Where consumers can substitute away from a taxed good over time, the demand becomes more elastic, and producers bear more of the tax. The time horizon therefore matters for the assessment of incidence.
Taxes on Labour and Capital
Tax shifting applies to taxes on labour and capital. A tax on labour, such as a payroll tax, may be shifted backward to workers through lower wages or forward to consumers through higher prices, depending on the elasticities of labour supply and demand and on the degree of competition in product markets.
A tax on capital may be shifted to labour, to consumers, or to owners of capital, depending on the mobility of capital and the elasticities of substitution. In an open economy with mobile capital, taxes on capital may be shifted to less mobile factors, a consideration in the design of tax systems.
Corporate Income Tax
The incidence of the corporate income tax has been extensively studied. Early analysis assumed that the burden fell on owners of capital, but more recent work emphasises that capital mobility and the openness of economies mean that part of the burden may be shifted to labour through lower wages.
The empirical evidence on the incidence of the corporate tax is mixed, and the magnitude of shifting remains debated. The analysis informs the assessment of tax policy and of the distributional effects of different tax instruments.
Incidence in Imperfectly Competitive Markets
The analysis of tax incidence is more complex in imperfectly competitive markets, where firms set prices above marginal cost. The extent to which a tax is passed on depends on the degree of competition, on the form of competition, and on the response of firms' markups.
In some models, firms absorb part of the tax by reducing their markups, so that the pass-through is less than complete. In others, the tax is fully passed on, or even more than fully, depending on the structure of the market. The analysis of pass-through in imperfect competition is an active area of research.
Tax Shifting and the Informal Sector
In economies with a large informal sector, the shifting of taxes is complicated by the ability of firms and workers to move between the formal and informal sectors. Taxes imposed on formal activities may drive activity into the informal sector, reducing the tax base and altering the incidence.
The design of tax policy must account for these responses, and the analysis of informality informs the assessment of tax instruments. The presence of an informal sector can limit the effectiveness of taxes and can affect the distribution of the burden.
International Tax Competition
In an open economy, taxes on mobile factors, such as capital and skilled labour, may be shifted to less mobile factors or to consumers, because the taxed factors can move to jurisdictions with lower taxes. This limits the ability of countries to tax mobile factors and creates pressure for international coordination.
The analysis of tax competition informs the design of international tax rules and the assessment of proposals for coordination. The challenges of taxing mobile factors in a globalised economy are central to contemporary debates about tax policy and about the distribution of the tax burden.
Empirical Estimates
Empirical estimates of tax incidence use a variety of methods, including the analysis of policy changes, of cross-country variation, and of micro-level data. The estimates vary, reflecting differences in the taxes studied, the populations affected, and the methods used.
The evidence informs the assessment of tax policy and the design of reforms. It highlights the importance of considering the full range of responses to taxation, including changes in prices, wages, employment, and the allocation of activity, in evaluating the effects of taxes on the distribution of income and on economic efficiency.