Tax Incidence
What is Tax Incidence?
Tax incidence refers to the distribution of the tax burden between buyers and sellers.
The incidence of a tax depends on the relative elasticities of supply and demand. If demand is more inelastic than supply, consumers bear a larger share of the tax burden. If supply is more inelastic than demand, producers bear a larger share.
Tax Incidence: a worked example
Take a market where the equilibrium price is $10 and 500 units trade. The government puts a $3 per-unit excise tax on sellers. In the new equilibrium buyers pay $12, so sellers keep 12 - 3 = $9 per unit. Buyers bear 12 - 10 = $2 of the tax, sellers bear 10 - 9 = $1, and the two shares add back to the $3 tax. Buyers are carrying 2/3 of the burden, which tells you demand is less elastic than supply in this market. If 420 units still trade, tax revenue is 3 x 420 = $1,260.
The mistake students make with tax incidence
Students assume whoever writes the check to the government is the one who pays. Who legally remits the tax is statutory incidence; who ends up poorer is economic incidence, and only the relative elasticities decide the second one. Put the same $3 tax on buyers instead of sellers and the split between them comes out identical, even though you shift a different curve to draw it. The legal wording is tempting because it is the one hard fact stated in the question.
Tax Incidence questions
Who pays the tax if demand is perfectly elastic?
Perfectly elastic demand puts the whole tax on sellers. With a horizontal demand curve, buyers walk away at any price above the going one, so sellers cannot raise the price at all and must absorb the entire per-unit tax out of what they keep. Flip it and the result flips: with perfectly inelastic demand, the price buyers pay climbs by the full tax. Testing the two extremes is the fastest way to check your reasoning.
How do you find tax incidence on a graph?
Tax incidence on a graph is read as two vertical pieces of the tax wedge. Mark the original equilibrium price, then the new price buyers pay and the new price sellers keep. The distance from the old price up to the buyers' price is the buyers' share per unit, and the distance from the old price down to the sellers' price is the sellers' share. Those two pieces sum to the full per-unit tax.
Does a tax on sellers shift supply or demand?
A tax on sellers shifts the supply curve, moving it up by exactly the per-unit tax at every quantity, because sellers now need that much more per unit to be as willing as before. A tax collected from buyers shifts demand down by the same amount instead. The drawings look different, but the price buyers pay, the price sellers keep and the burden split all end up the same.
This is the live Supply and Demand sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
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