Question

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

Incidence of tax measures the effect of a tax on the society by measuring the tax burden falling on the society. A tax creates a wedge between the price that is paid by consumer and the price that is received by the producer. Tax incidence measures this difference

It is related to the price elasticity of supply and demand because how much price is increased for consumers and how much price is decreased for producers depend upon the elasticity of demand and supply. The greater the elasticity of demand or supply in numeric terms, the lesser will be the tax burden.

For example, if supply is relatively inelastic, producers are expected to bear a greater tax burden. If demand is relatively inelastic, consumers are expected to bear a greater tax burden. In specific cases, when demand is perfectly inelastic, entire tax burden is borne by the consumer and supply is perfectly inelastic, producers bear the entire tax burden

For public policy proposals it is necessary to understand the tax incidence. There are particular taxes such as sin taxes which are imposed in the markets with inelastic demand. This helps in increasing the government revenue by a greater amount because when demand is inelastic, the resultant deadweight loss is smaller and generated tax revenue is greater. If tax is imposed in a market with elastic demand, there will be a greater wastage of resources in terms of deadweight loss and a little revenue will be generated.