Tax Incidence: How the tax Burden is Shared Between Buyers and Sellers
Taxes are an important source of revenue for the government. However, taxes decrease both supply and demand in the market. Buyers have to pay a higher price and sellers receive less for their product. Sometimes the government tries to divide the burden of the tax, such as the federal government does with the payroll tax, requiring both employer and employee to pay one half of the tax, which currently is 15.3% of wages paid.
However, do employers and employees actually pay only one half of each tax? After all, if employers have to pay one half of the payroll tax, then they can simply pay their workers less to compensate for their share of the tax. On the other hand, laborers can decide not to work for less than what they want to earn plus the burden of the payroll tax. As will be seen from considering the supply and demand and their elasticities, the actual tax incidence, which is defined as the actual burden that each transaction participant shares, cannot be mandated by law, but depends on the respective elasticities of both supply and demand.
To better see how the elasticity of supply and demand affects tax incidence, consider a 20% tax on a can of soda. Suppose the government decides that the buyer should pay the 20% tax. Does this mean that the buyers will be paying 20% more, or will sellers have to share some of the tax burden? Since higher prices decrease demand, regardless of the reason for the higher prices, sellers will share some of the burden. How much of the burden will be determined by the elasticity of supply and demand for the product.
Only if either demand or supply was either completely elastic or inelastic will the tax burden fall entirely on either the buyer or the seller. Between these 2 extremes, tax incidence varies continuously from a perfectly inelastic supply or perfectly elastic demand, where the buyer assumes the entire burden of the tax to the perfectly elastic supply or perfectly inelastic demand where the sellers bear the entire burden. As can be seen in the diagrams below, the tax burden will fall more on the buyer if demand is inelastic or supply is elastic, but will fall more on the seller if demand is elastic or supply is inelastic.
Note that in the 4 diagrams below, a tax on a particular product increases its price and decreases the quantity supplied, since suppliers are getting less revenue for their product. The assessed tax shifts the supply curve upward, from S to St, the price increases from P to Pt, and the quantity declines from Q to Qt. But how the tax incidence, or tax burden, is shared between buyer and seller depends on the elasticity of both demand and supply. The buyer bears a greater portion of the tax burden when either demand is inelastic or supply is elastic, as depicted in diagrams # 1 and # 4, respectively. When demand is elastic or supply is inelastic, then the seller bears the major portion of the tax, as depicted in diagrams # 2 and # 3, respectively. |
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Does a Tax Shift the Demand or Supply Curve?
The above diagrams shows how the tax incidence on buyer and seller is
apportioned by a tax assessed on the seller by showing it as a shift in the
supply curve caused by the tax. A similar argument can be made for a tax on the
buyer. Some have argued that these shifts in the curves occurs because the
quantity supplied or demanded is less with the tax then without it.
A typical demand or supply curve shows the relation between the price and the quantity that is either demanded or supplied. The
market equilibrium is where the 2 curves intersect. Any change in price results in a shift
along the demand or supply curve. However, if demand or supply changes because of changes in other
demand or supply determinants, then there is a shift
in the demand or supply curve, where the quantity is different for every price point.
Some have argued that, with the buyer's tax, there is a shift in the demand curve because the buyer buys less at each price. However, the traditional demand-supply diagram simply relates how quantities change in relation to the price — regardless of the reason for the change in price. The demand depends only on the price, not on who gets the money. Likewise, for sellers, the quantity supplied depends on the price that they receive – that the buyer pays a higher price makes no difference to them. They supply according to the schedule of the prices that they actually receive.
Some people have argued that to determine the tax incidence of a tax, one must first decide whether the demand curve or the supply curve has shifted, then find a new market equilibrium. However, I believe that this unnecessarily complicates the analysis. A tax does not shift either the demand or the supply curve at all. In the traditional supply-demand diagram, there is a tacit assumption that the seller receives what the buyer pays. However, the imposition of the tax means that the buyer will pay more than what the seller receives — the difference goes to the government. Therefore, the demand and supply curve do not, in actuality, intersect. Instead, there are 2 new equilibria — the
buyer's equilibrium price and the seller's equilibrium price. The tax incidence can still be measured by the elasticities of demand and supply, but it is unnecessary to shift either curve.
As can be seen in the graphs below, how the tax burden between buyer and
seller varies with the elasticity of demand and supply can be shown without
shifting either the demand or supply curve. In graph #1, buyer and seller share
of the tax burden equally, since their elasticities are unitary. In graph #2,
where demand is elastic but supply is inelastic causes most of the tax burden to
fall on the seller. In graph #3, where demand is inelastic but supply is
elastic, the tax burden falls mostly on the buyer.
Buyer's Tax Burden = Price Buyer Pays - Market Price without
the Tax = Pb - Pm
Seller's Tax Burden = Market Price without the Tax - Price
Seller Receives = Pm - Ps
Sales and Excise Taxes
The elasticity of demand is often considered when governments consider assessing sales or excise taxes on products or services. Generally, because sales taxes are assessed on many items, buyers bear most of the burden of sales taxes, since there are few other things that they can buy that are tax-free. On the other hand, excise taxes, which are taxes on particular products, would, in many circumstances, hurt the sellers more because buyers can buy untaxed goods. This elastic demand pushes the tax burden on the sellers. However, there are some items where demand is inelastic because there are no close substitutes, such as alcohol and tobacco, so the tax burden for these items falls more on the buyers.
Property Taxes
Buyers can choose what property they want to buy, but sellers have no choice other than to sell the property that they own. Since most buyers consider how much tax they will have to pay on the property when making offers, the tax burden will most often fall on the seller of the property. However, if the property is rented out, then the landlord can easily pass the cost of taxes on to the tenant. A business that serves a locality can also usually shift the cost of property taxes on to consumers, since property taxes are part of the cost of providing the product or service and the same tax rates are usually assessed. However, a business serving an international market will probably suffer most of the tax burden, since the prices that can be charged will be determined by the international market, and where competitors can be located anywhere in the world, where there is considerable variation in property taxes.
The Tax Incidence on Labor
In regard to the labor market, labor is the supply and wages are the price of labor. Because the supply of unskilled labor is highly inelastic, unskilled workers bear most of the burden of the payroll tax.
However, when workers offer valuable skills, they are generally much more highly compensated because there is more competition for their abilities and services. Thus, highly compensated individuals bear less of the burden of the payroll tax than the employers. Hence, the tax incidence of the payroll tax falls more heavily on low income workers than on higher income workers.
Personal Income Taxes
Since personal income taxes directly reduce disposable income, the taxpayer bears most of the burden of personal income taxes, although retail sellers and others selling directly to consumers will bear some of the burden in reduced sales.
Corporate Income Taxes
Generally, corporations competing in a competitive market are price takers, so the prices that they can charge are determined by the market. So unless the corporate income tax is assessed on every market participant equally, the corporation generally bears the burden of the income tax. However, corporations with monopoly power are price setters, which allows them to pass most of the cost of taxes to consumers.
Luxury Taxes
In 1990, Congress assessed a new luxury tax on goods generally sold to the wealthy, such as expensive cars, jewelry, yachts, private airplanes, and furs. The purpose of the luxury tax was to assess taxes on the segment of society that can most easily afford it. However, the wealthy can do many things with their money besides buying luxury items. They can travel around the world, move to places with lesser taxes, host lavish parties, buy expensive houses, or give most of their wealth to their family members. Instead of taxing the wealthy, the luxury tax hurt the workers who provided the luxury products, since their supply was inelastic. After all, the people who manufacture private airplanes or yachts have few other options for jobs. Likewise, these manufacturers cannot easily convert their facilities to produce something else, especially to produce lower-priced items that would appeal to the masses. So the manufacturers and the workers who provided the luxury goods paid most of the burden of the luxury tax. Subsequently, in 1993, Congress repealed the tax on airplanes and yachts, but not expensive cars, since auto manufacturers can easily shift production to lower-cost vehicles.
