Tax Incidence
Tax incidence describes how the burden of a tax is distributed among the participants in a market, including consumers, producers, workers, and owners of capital. The economic incidence of a tax is not determined by the legal obligation to pay it, but by the responses of buyers and sellers to the change in prices. Understanding incidence is essential to the analysis of tax policy, since the effects on the distribution of income can be very different from what the legal form of the tax suggests.
Statutory versus economic incidence
The statutory incidence refers to who is legally required to remit the tax to the government, while the economic incidence refers to who ultimately bears the burden. A tax levied on sellers may be passed on to buyers through higher prices, and a tax levied on buyers may be borne partly by sellers through lower prices received. The statutory form does not determine the economic outcome, which depends on the responses of the parties to the tax.
The distinction is important because it implies that the legal form of a tax cannot be used to determine its distributional effects. A payroll tax levied on employers and one levied on employees may have the same economic incidence, since the burden depends on the elasticity of the demand for and supply of labour, not on the legal obligation. The analysis of tax policy must therefore focus on the economic incidence.
Determinants
The economic incidence of a tax depends on the relative elasticities of supply and demand. The side of the market that is less elastic bears a larger share of the tax, because it has less ability to change its behaviour in response to the tax. 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.
In labour markets, the incidence of a payroll tax depends on the elasticity of labour supply and of labour demand. If labour supply is inelastic, workers bear most of the tax through lower wages; if labour demand is elastic, employment falls and the burden is shared. The incidence also depends on the structure of the market, including the presence of market power, and on the time horizon, since elasticities are larger in the long run.
Examples
A tax on a product with inelastic demand, such as a tax on fuel, is borne largely by consumers, because they do not reduce consumption much in response. A tax on a product with elastic demand, such as a tax on a luxury good with many substitutes, is borne largely by producers, because consumers switch to alternatives. A corporate income tax may be borne by shareholders, by workers, or by consumers, depending on the openness of the economy and on the mobility of capital.
In internationally integrated markets, the incidence of a corporate tax depends on the mobility of capital. If capital is highly mobile, the tax may be shifted to labour through lower wages, because firms can relocate to avoid the tax. If capital is less mobile, the tax may fall on the owners of capital. The incidence therefore depends on the openness of the economy and on the mobility of the factors of production.
Implications
The analysis of incidence has important implications for policy. It shows that the distributional effects of a tax cannot be inferred from its legal form, and that the design of tax policy must consider the responses of the parties. It implies that the burden of a tax may fall on groups other than those intended, and that the redistributional effects of a tax may be different from what was expected.
The analysis also informs the design of tax systems. If the objective is to raise revenue with minimal distortion, taxes should be levied on bases that are less elastic, since these generate less change in behaviour. If the objective is to redistribute, the incidence of the tax must be considered alongside its formal structure, and transfers may be more effective at achieving distributional objectives than adjustments to the tax itself.
Partial and general equilibrium incidence
The analysis of tax incidence distinguishes between partial equilibrium, which considers the market for the taxed good in isolation, and general equilibrium, which considers the effects across all markets. In a partial equilibrium analysis, the burden of a tax depends on the elasticities of demand and supply in the taxed market. In a general equilibrium analysis, the effects propagate through the economy, affecting prices, wages, and returns in other markets.
The distinction matters when the taxed market is large or when the tax affects important inputs. A tax on labour, for example, affects wages, employment, and the returns to capital throughout the economy, and its incidence depends on the elasticities of substitution between labour and capital and on the mobility of factors. The general equilibrium analysis is more complex, and it reveals effects that the partial equilibrium analysis misses.
Incidence and factor mobility
The incidence of a tax on the returns to a factor depends on the mobility of that factor. If capital is highly mobile internationally, a tax on capital may be shifted to labour through lower wages, because firms can relocate to avoid the tax, and the burden falls on workers. If capital is less mobile, the tax falls on the owners of capital, and the incidence is as expected.
The mobility of labour also matters. If workers can move between sectors or regions, the burden of a tax on employment in one sector may be shifted to workers in other sectors, through changes in wages. The incidence of a tax therefore depends on the mobility of the factors of production, and it is affected by the openness of the economy and by the flexibility of markets.
Empirical evidence
Empirical research on tax incidence uses a combination of methods, including the analysis of tax reforms, the comparison of jurisdictions with different rates, and the estimation of structural models. Studies of the incidence of corporate taxes, for example, have found that a substantial share of the burden falls on labour through lower wages, particularly in open economies with mobile capital, while the share falling on shareholders is smaller than was once assumed.
Studies of consumption taxes find that the burden is largely passed on to consumers through higher prices, with the share depending on the competitiveness of the market. Studies of payroll taxes find that the burden is shared between employers and employees, with the division depending on the elasticities of labour demand and supply. The evidence informs the design of tax policy and the assessment of its distributional effects, and it shows that the incidence is often different from the legal form of the tax.
Policy implications
The analysis of incidence has important implications for the design of tax policy. It shows that the burden of a tax cannot be determined from its legal form, and that the distributional effects depend on the responses of the parties. It implies that the design of a tax must consider the market in which it operates and the responses it will induce, and that the objectives of revenue and distribution may require different instruments.
The analysis also informs the international dimension of tax policy. In an open economy with mobile capital, the ability to tax capital is constrained by the threat of relocation, and the burden may fall on less mobile factors. International coordination, including agreements on minimum taxes and on the sharing of information, can address the erosion of the tax base and the shifting of profits, and it supports the ability of countries to raise revenue fairly and efficiently.