Tax Incidence: Definition, Example, and How It Works

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Tax Incidence: Definition, Example, and How It Works

What Is a Tax Incidence?

The phrase “tax incidence” (or incidence of tax) refers to the split of a tax burden among stakeholders such as buyers and sellers or producers and consumers. Tax incidence is also connected to supply and demand price elasticity. When supply is more elastic than demand, the buyer bears the tax burden. If demand is more elastic than supply, the tax will be borne by producers.

Key Takeaways

  • A tax incidence depicts a situation in which purchasers and sellers share a tax burden.
  • A tax incidence will also specify who bears the cost of a new tax, such as producers and consumers or different class divisions of a community.
  • The elasticity of a good’s demand may aid in understanding the tax incidence among parties.

How a Tax Incidence Works

The tax incidence indicates the allocation of the tax liabilities that the buyer and seller must cover. The extent to which each party contributes to meeting the obligation varies according to the related price elasticity of the product or service in question, as well as how the product or service is presently influenced by supply and demand principles.

Tax incidence determines whether a new tax will be paid for by consumers or producers. Prescription medication demand, for example, is generally inelastic. Regardless of price adjustments, its market will stay largely stable.

Levying New Taxes on Inelastic and Elastic Goods

Another example is that cigarette demand is usually inelastic. When governments levy a cigarette tax, manufacturers raise the selling price by the entire amount of the tax, shifting the tax burden to consumers. Price has little effect on cigarette demand, according to study. Of course, this idea has limitations. Consumer demand would diminish if the price of a pack of smokes suddenly jumped from $5 to $1,000.

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If additional taxes are imposed on an elastic product, such as fine jewelry, the majority of the burden is likely to transfer to the producer, since a price rise may have a considerable influence on demand for the linked commodities. Elastic products are those that have near replacements or are non-essential.

Price Elasticity and Tax Incidence

Price elasticity depicts how buyer behavior varies in reaction to changes in the price of an item or service. Demand is considered to be inelastic when the customer is likely to continue buying an item or service notwithstanding a price adjustment. When the price of an item or service has a significant influence on the amount of demand, the demand is said to be highly elastic.

Gasoline and prescription drugs are two examples of inelastic products or services. With price adjustments, the overall level of consumption stays stable. Elastic items are ones whose demand is heavily influenced by price. This category contains luxury items, residences, and apparel.

The following is the formula for calculating the consumer’s tax burden, with “E” signifying elasticity:

  • E (supply) + (E (demand)) (supply)

The following is the formula for calculating the producer or supplier’s tax burden, with “E” signifying elasticity:

  • E (demand) / (E (supply) + E (demand))

What Does Tax Incidence Determine?

Tax incidence indicates who or what eventually suffers the cost of a tax, as opposed to merely who pays the tax directly.

Are Consumers or Retailers Impacted More By Tax Incidence?

Tax incidence may affect a variety of parties, such as when a customer must pay higher sales taxes and so spends less at a shop, harming the company’s sales and perhaps resulting to job layoffs or store closures.

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What Is Elastic Vs. Inelastic Demand?

Elastic demand is demand that grows or decreases in response to the price of a service or product, the situation of the economy, or the individual’s financial health. Inelastic demand is demand that is unaffected by price changes, the status of the economy, tax incidence, or any other financial issue. It is the distinction between purchasing leisure or self-care items vs purchasing food and medication.

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