Question

Tax incidence. Determine graphically the incidence (on buyers and sellers) of a unit tax imposed on sellers. Show how changes in demand elasticity change the relative incidence.

Answer 1

Tax incidence is the way the tax burden is broken down between buyers and sellers.

The tax incidence depends on the relative supply and demand elasticity of the rates. When supply is more elastic than demand, buyers will bear the greater part of the tax burden. Where demand is more dynamic than supply, producers should bear much of the tax burden.

The larger the tax revenue the more inelastic the supply and demand.

The burden of tax can, depending on the circumstances, fall more on consumers or on producers. For example, in the case of cigarettes, demand is inelastic; since cigarettes are an addictive substance and taxes are mainly passed on to consumers in the form of higher prices.

Usually, the incidence or burden of a tax falls on both consumers and producers of the taxed good. Yet if we want to determine which community will bear the bulk of the strain, all we need to do is analyze demand and supply elasticity.

In the example by above tobacco the tax burden falls on the market's most inelastic side. If demand is more inelastic than supply, the majority of the tax burden is on the consumers. But, if supply is more elastic than demand, sellers bear most of the burden of taxation.

So if demand is inelastic, consumers are not very responsive to price changes, and when tax is introduced, the quantity demanded remains relatively constant. In the scenario of smoking, the demand is inelastic, as consumers are addicted to the product. The seller can then pass the tax burden on consumers in the form of higher prices without much decline in the quantity of balance.

If a tax is incorporated in a market with an inelastic supply, such as Hotel Industry, sellers have no choice but to accept lower prices for their business. Taxes do not significantly affect the quantity of equilibrium. In this case, the tax burden is on the sellers. If the supply were flexible and the sellers had the opportunity to reorganize their businesses in order to avoid supplying the taxed goods, the tax burden on the sellers would be much lower and the tax would result in a much lower quantity sold instead of lower prices received. The connection between the tax incidence and the elasticity of demand and supply can be seen graphically below.

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