Tax Incidence

In a previous article, I discussed the importance of understanding elasticities (the responsiveness of units supplied or demanded to the price fluctuations) in welfare analysis. In this article, I will discuss how this affects a very important concept, tax incidence.

Tax incidence is the term used to describe who truly pays a tax. If a $50 tax is placed on a good- for instance, washing machines- the tax incidence attempts to measure who is paying the $50. It would be foolhardy to assume it all falls on the consumer. If Whirlpool could charge an extra $50 and not reduce demand, then they would already price their washing machines higher. The price after-tax usually falls somewhere in between $0 and $50 higher than the original price (ceteris paribus).

In this example, let’s consider that the price after tax raises $30. Demand will fall accordingly, and a large brunt of the incidence lies on those who still need to purchase washing machines. This would include renters who are furnished by their landowners (who could pass off the extra investment in higher rents). This could include higher prices for Laundromats, as well as any number of other unintended consequences.

With inelastic demand, the consumer pays. (Wikipedia)

On the supply side, however, Whirlpool still pays for the tax. Not only do they receive $20 less per washing machine sold ($50 tax taken out of the $30 price increase), they have reduced number demanded. They will be shifting their production schedules accordingly. Who could this affect? It could mean layoffs (possible), decreased shareholder equity (probable) and reduced demand for factors of production* (definitely). This means that the companies who are manufacturing the parts will see reduced demand. The tax incidence rifles its way through the entire line of production.

This example shows a bit how various forms of taxation are felt by different levels of the economy. But, how do price elasticities affect the incidence of the tax? If the demand is extremely inelastic (as argued previously on DQYDJ about cigarettes or medicine) the incidence will be felt mainly by the consumer. Consumers will not trade out of medicine for a lower alternative because it is a necessity. On the other hand, if goods with relatively elastic demands (think fruits or cars) is taxed, alternatives may be explored. An apple tax will increase the demand for oranges, and a tax on cars will increase use of bikes, motorcycles and public transportation.

With elastic demand, the incidence lies on the producer (Wikipedia)

Let’s take a real world example. A previous article by colleague PK gave one argument for higher gas taxes. Gas prices are an inelastic good. Consumption changes in petroleum do not match the magnitude of the price changes. Due to this, we would expect the tax incidence to fall largely on the consumers. Contrarily, finished petrol price elasticities of supply are inelastic. A very fungible good such as gasoline means firms cannot price differentiate. Due to the decreased demand, the competitiveness of the gasoline market will keep the prices low. How do these two contrary effects balance each other?

Comparable elasticities split the incidence

This paper claims that the tax incidence falls almost fifty-fifty on the producers and consumers. As mentioned in our previous gasoline tax article, there are many benefits to increased gasoline taxation, because the expenditures benefit those where the incidence lies. In other words, if you do drive, you do not benefit from public roads as much as those who do drive. Because of this, the incidence should be on those who drive (the consumers in this example). Here is an example where the incidence is appropriately distributed.

Cheers,

Cameron Daniels

*Yes, layoffs are an example of reduced demand for factors of production

Some links for analysis on the price elasticity of crude oil or petroleum:

http://www.ftc.gov/reports/gasprices05/050705gaspricesrpt.pdf

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.141.6166&rep=rep1&type=pdf