Question

4.) What is tax incidence? How does it relate to price elasticity of supply/demand? How might understanding tax incidence be important when evaluating public policy proposals?

Answer 1

Tax incidence (or incidence of tax) is an economic term for understanding the division of a tax burden between stakeholders, such as buyers and sellers or producers and consumers. When supply is more elastic than demand, the tax burden falls on the buyers. If demand is more elastic than supply, producers will bear the cost of the tax.In economics, tax incidence or tax burden is the effect of a particular tax on the distribution of economic welfare. Economists distinguish between the entities who ultimately bear the tax burden and those on whom tax is initially imposed. The tax burden measures the true economic weight of the tax, measured by the difference between real incomes or utilities before and after imposing the tax. An individuality on whom the tax is levied does not have to bear the true size of the tax.Tax incidence can also be related to the price elasticity of supply and demand.

Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It is computed as the percentage change in quantity demanded—or supplied—divided by the percentage change in price.Both demand and supply curves show the relationship between price and the number of units demanded or supplied. Price elasticity is the ratio between the percentage change in the quantity demanded, \text{Q}_dQd​start text, Q, end text, start subscript, d, end subscript, or supplied, \text{Q}_sQs​start text, Q, end text, start subscript, s, end subscript, and the corresponding percent change in price.The price elasticity of demand is the percentage change in the quantity demanded of a good or service divided by the percentage change in the price. The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price.

Typically, the incidence, or burden, of a tax falls both on the consumers and producers of the taxed good. But if we want to predict which group will bear most of the burden, all we need to do is examine the elasticity of demand and supply.

In the case of cigarettes, for example, demand is inelastic—because cigarettes are an addictive substance—and taxes are mainly passed along to consumers in the form of higher prices, the tax burden falls on the most inelastic side of the market. If demand is more inelastic than supply, consumers bear most of the tax burden. But, if supply is more inelastic than demand, sellers bear most of the tax burden.

Think about it this way—when the demand is inelastic, consumers are not very responsive to price changes, and the quantity demanded remains relatively constant when the tax is introduced. In the case of smoking, the demand is inelastic because consumers are addicted to the product. The seller can then pass the tax burden along to consumers in the form of higher prices without much of a decline in the equilibrium quantity.

When a tax is introduced in a market with an inelastic supply—such as, for example, beachfront hotels—sellers have no choice but to accept lower prices for their business. Taxes do not greatly affect the equilibrium quantity. The tax burden in this case is on the sellers. If the supply were elastic and sellers had the possibility of reorganizing their businesses to avoid supplying the taxed good, the tax burden on the sellers would be much smaller, and the tax would result in a much lower quantity sold instead of lower prices received.

Public policy is the process by which governments translate their political vision into programmes and actions to deliver ‘outcomes — desired changes in the real world’.

An issue encountered in public policy evaluation is the issue of incidence: the ultimate beneficiary of the policy is not necessarily the individual targeted. This issue is frequent in the case of taxation or subsidies/transfers. Tax incidence theory reveals that the burden of taxation may not ultimately fall upon the person who writes the cheque for it: the parties taxed may pass on the cost of the tax to others; inversely, individuals not originally targeted by a subsidy may indirectly find that they are its beneficiaries.

An illustration of this is provided by housing benefits. In 2009 this rental subsidy constituted a quarter of all benefits paid to French households. If the households officially receiving these benefits were the actual beneficiaries, housing benefit would account for over one-fifth of the reduction in inequality in living standards achieved by the welfare system. However, this redistributive action is questioned considering that between 50% and 80% of these benefits in fact benefit lessors through increased rents as a result of market mechanisms (housing supply and demand): because the rental offer does not change very much in the short and medium term, demand subsidies raise rents, such that the support intended for disadvantaged tenants is in part received by the owners of rental accommodation. This example reveals that a policy of this type cannot be evaluated simply by limiting our enquiry to means or to the number of households receiving the benefit. Any analysis of housing benefit that fails to take into account its impact on rents would lead to an overly optimistic assessment.

Furthermore, the effect of the policy can result detrimental to those persons not benefiting from the policy. This is the case with lessees who do not receive housing benefit (they are affected by increased rents) – not to mention the additional taxation required to finance the policy.