The expression “tax incidence” refers to how producers and consumers share the burden of the tax, and that is another way of answering the question of who pays the bigger chunk, will it be shared equally, or will one party face the full brunt of it.
Prepare to be surprised: this sharing has nothing, zero, nothing, nada! to do with who is supposed to pay for the tax, and that is the party to whom the tax is “officially” applied. In other words, it does not matter who has the legal obligation to pay for the tax. Read again. It. Does. Not. Matter.
Pretty mind-blowing, I know. What matters then? What is elastic and rhymes with “electricities?” Ha, elasticities, of course! And yes, if you must know, I struggled with a rhyme (insert sad emoji).
Elasticities & Tax Burden
To see why elasticities determine the answer, consider the following. Suppose that every Sunday you buy ice cream, typically 5 tubs (hey, don’t eat it all at once!). This week, you go to the store to find that, overnight, the government imposed a 100% tax on consumers of ice cream. This effectively doubles the price of ice cream (ouch!). Needless to say, you are not happy about this. Now consider the following three scenarios…
Scenario #1: That’s it, No More Ice Cream!
You get so annoyed that you decide to buy something else, say frozen yogurt or cheesecake, whose prices did not change. When you do this, you will effectively avoid paying for the tax, but you will also not consume any ice cream. My point is that, by altering your behavior, you avoided paying for the tax.
Specifically, your price elasticity of demand was so high that you exhibited a huge response to the price change, and by doing so you paid nothing of the tax. No ice cream yummy in the tummy, though.
Scenario #2: I’ll Buy Less Ice Cream.
Okay, so maybe stopping to buy ice cream was a bit extreme, way too dramatic. Suppose you still buy some ice cream but, because it is more expensive, you now only buy 2 tubs (still a lot of ice cream). This means that you will be giving some of your hard-earned $ to Uncle Sam, but definitely not as many as you would be giving if you kept buying the same 5 tubs of ice cream as before.
My point is, by adjusting the quantity you purchase, you are effectively paying less in taxes than if you stuck to buying your typical 5 tubs of ice cream.
Scenario #3: I Can’t Live Without Ice Cream!
Now let’s imagine you are crazy about ice cream. Indeed, “ice cream” is your answer to the “name me one thing that you can’t live without” question. In this case, you probably would buy your usual 5 tubs of ice cream (hey, cut on something else).
My point is that, by not adjusting the quantity you purchase, you are exhibiting zero sensitivity to the price change. This happens when Demand for goods is inelastic, for example when there aren’t substitutes immediately available or not enough time to adjust.
Okay, so maybe my example with ice cream sounds a bit too far-fetched. So… what if instead of ice cream, we’re talking about gas? If gas prices double tomorrow, can you get by without fueling up your car? Maybe if I give you enough time you can figure something out, say carpool, bike to school, even move closer to school or your job but, in the very short-run, odds are you have to bite the bullet. In this case, you are completely unable to adjust the quantity you purchase, so you fill up your tank and pay as much tax as you have to.
What I am trying to do by mentioning these examples and the different scenarios is to make you reflect about one’s ability to adjust to a price change, from not buying the good at all to buying as much as before. This matters to how much of the tax one bears.
Tax Burden & Elasticities: Ta-Da!
Ceteris paribus, the more sensitive to price changes the consumers, i.e. the more elastic the Demand, the less the burden of the tax the consumers will bear. Conversely, the less sensitive to price changes the consumers, i.e. the more inelastic the Demand, the more the burden of the tax the consumers will bear.
Now you could tell me that, so far, I have only spoken about consumers, and have pretty much stayed silent about producers. It turns out, a similar logic applies to producers. Ceteris paribus, the more sensitive to price changes the producers, i.e. the more elastic the Supply, the less the burden of the tax the producers will bear. Conversely, the less sensitive to price changes the producers, i.e. the more inelastic the Supply, the more the burden of the tax the producers will bear.
In general, the greater the elasticity demonstrated by a party in the exchange, the smaller the burden of the tax they will bear.
Joana Girante 