TAX INCIDENCE AND BURDEN

The simplest notion of tax incidence (formal incidence) concerns the question of who is assessed to pay a tax. Thus, the formal incidence of an income tax falls on the income earner; the formal incidence of a petrol tax falls on the petrol company. On the other hand, the tax burden is the person or institution that eventually bears the responsibility of paying the tax (who carries the burden created by tax imposition). In some cases the tax incidence may be on the same person as the tax burden (example of income tax) but in most cases it’s the customer or the final users who bears the burden. In the example of petrol tax above, Petrol Company may pass on an increase in tax in the form of higher prices. By so doing the company shifts the burden of the tax on to the consumer (this is known as forward shifting of the tax burden). Therefore, the effective incidence or economic incidence of the tax falls on motor vehicle owners. However, if we look more deeply we may be able to distinguish a number of other effects. Some vehicle owners (taxi drivers, bus companies, carrying firms) may be able to pass the increased cost of petrol on to others. Thus, part of the effective incidence of an increase in petrol tax may be on bus passengers or on consumers of food transported by Lorries.

Suppose the government increased the tax on cigarettes. Who would be affected from that tax increase? Technically only cigarette manufacturers are paying the tax to the government. Cigarette buyers, cigarette wholesalers, or tobacco farmers are not paying the tax to the government. But we know that cigarette manufacturers will shift a portion of that tax burden to the cigarette wholesalers and retailers. Cigarette wholesalers and retailers will shift a portion of its share to the cigarette buyers. Therefore, tax incidence will be on manufacturers but burden is on buyers.

It is possible to come to some theoretical conclusions about the possibility of shifting the tax burden. For instance, it can be shown that if a tax were applied to a good that was perfectly inelastic in demand, producers would be able to shift the full burden of the tax on to consumers. On the other hand, with perfectly elastic demand, it would be impossible for producers to increase the price of the product to take account of the tax - the tax burden would be borne fully by the producer. Of course, in the usual cases where demand is somewhere between perfectly elastic and perfectly inelastic, the burden would be divided amongst consumer and producer but the more elastic the demand, the more of the burden would be shifted on to the consumer.