What is Tax Incidence Analysis?

Tax incidence analysis is a kind of economic analysis. It helps to understand the division of tax burden between stakeholders. Tax incidence also relates to the price elasticity of demand and supply. The producers and consumers may valuate their tax burden with the help of tax incidence analysis. It also helps to calculate the burden of a new tax. It is the effect of a particular tax and analysis of tax occurrence in the economy.

The tax increase may decrease in demand and vice versa. In the same way increase in tax may increase the price of goods or services and hence decrease in sells and vice versa.

Factors Determining Tax Incidence

1. Elasticity: Elasticity of supply and demand determines the incidence of taxation.
2. Price: The price of goods or services gets shifted due to an increase or decrease in tax burden.
3. Time: Time is a very important factor. In the long run buyers and sellers have time to adjust the price due to the tax burden.
4. Nature of tax: The nature of tax is also an important factor in tax incidence analysis. For example, indirect taxes are paid by consumers.

How does Tax Incidence Analysis Work?

The distribution of tax obligation which is a must for producers and consumers to be covered is depicted in tax incidence. Incidence of tax analysis defines the group of buyers and sellers who are obliged to pay a new tax. Tax incidence or tax burden explains which group in the economy (buyers or sellers) will pay the price of tax.

Levying New Taxes on Elastic and Inelastic Goods

Inelastic goods are those whose demand is relatively inelastic. For example, producers increase the price of cigarettes because the government imposes a heavy tax rate on the cigarette. This is because the demand for cigarettes is investigated to be inelastic. So, the sellers transfer the tax burden to the buyers.

If the government imposes new taxes on elastic goods such as jewelry, the tax burden would most probably shift to the producer as the demand for such goods may get affected due to heavy tax.

Relationship Between Price Elasticity and Tax Incidence

Price elasticity refers to the proportionate change in the quantity demanded of a product due to a proportionate change in the price of that product. When the quantity demanded of the goods or services remains unaffected, it is said to be inelastic, whereas when the quantity demanded of goods or services is affected due to price changes it is considered elastic.

For example, the demand for medicines, food items are said to be inelastic as the quantity demanded is not affected much due to price changes. Whereas the quantity demanded of luxury goods, clothing, etc. gets affected in a greater amount due to price changes and hence said to be elastic.

Consumer Surplus

The difference between what a buyer is willing to pay and what he actually pays for particular goods or services is termed consumer surplus. Consumer surplus theory helps the producers to decide the price of a product.

The economic theory of marginal utility describes the consumers’ willingness to purchase a given unit of output. In the marginal utility theory, the consumer gains additional satisfaction by purchasing one more unit of output. But, if he continues to consume more and more of that output, eventually the marginal utility decreases.

Measurement of Consumer Surplus

Consumer surplus is calculated with the help of the demand curve. Representation of the relationship between the price of the product and the quantity of the product which is demanded by the consumer is called the demand curve.

The law of diminishing marginal utility shows that the demand curve is downward sloping.

The area below the downward sloping demand curve is considered as consumer surplus.

For example, the consumption of cookies increases after the consumption of chocolates as the buyer may be fully satisfied with the consumption of chocolate. This is an example of the diminishing marginal utility of chocolates.

Formula for calculating consumer surplus:

$\text{Consumer surplus = The maximum price a consumer willing to pay }–\text{ The price that is actually paid}$

Consumer Surplus and Tax Incidence Analysis

Formula for calculating consumer tax burden:

$\text{Tax}\text{burden}\text{of}\text{consumer}\text{=}\frac{\text{E}\left(\text{demand}\right)}{\text{E}\left(\text{supply}\right)}\text{+ E}\left(\text{supply}\right)$

E represents elasticity

Producer Surplus

Producer surplus refers to the difference between how much a producer is willing to get for the amount of goods or services and what he actually receives. It is the total amount what the producer gains from selling goods and services.

The formula for producer surplus is

$\text{Producer surplus = Total revenue }–\text{ Total cost}$

The supply curve shows the marginal cost of producing units and is the sum of producer's total cost of output.

When the market price of the goods increases, producers are willing to produce more.

When the market price of the goods or services decreases, producers are willing to produce less.

Producer surplus is a measurement of economic welfare obtained by the producer in the market supply. Keeping other factors constant, producer wellbeing depends on market price.

Formula for calculating producer tax burden:

$\text{Producer surplus tax burden = }\frac{\text{E }\left(\text{demand}\right)}{\text{E}\left(\text{demand}\right)}\text{+ E}\left(\text{supply}\right)$

E represents elasticity

Tax Incidence in Competitive Market

 In the competitive market, the firms supply products that are equal to the marginal cost of goods. If the tax increases on a particular product, the marginal cost of the concerned goods or services increases.

For example, the tax of orange is $1, the price is said to be inelastic if the farmer can shift the tax burden to its consumers. The consumer will then bear the entire tax burden. Hence the tax incidence falls on the consumers. However, when the demand for the product is inelastic, the tax burden is borne by the producers.

• Tax burden analysis describes how different social classes subsidize the public sector.  The distribution of tax burden is carried out at a comparative level.
• Tax incidence analysis helps to predict whether it is profitable or not.

Context and Applications:

• Master in Business Administration
• Masters in Commerce
• Masters in Economics
• Bachelor of Economics
• Bachelor of Commerce