What Is Tax Incidence: Understanding Economic Burden and Market Dynamics

Key concepts of tax incidence

• Economic burden vs. legal responsibility: Tax incidence analyzes who actually bears the cost of a tax, which may differ from who is legally required to pay it

• Price elasticity impact: The elasticity of supply and demand significantly influences tax incidence:

  • When supply is inelastic and demand is elastic, producers bear more of the tax burden
  • When supply is elastic and demand is inelastic, consumers bear more of the tax burden

• Shifting of tax burden: Businesses can sometimes shift their tax burden to other parties through price adjustments in transactions

• Total tax burden: The overall burden of a tax often exceeds the actual revenue collected due to inefficiency costs, except for lump sum taxes

Factors affecting tax incidence

Market conditions

• Supply and demand elasticities: The party with more inelastic behavior bears a larger share of the tax burden

• Market structure: The degree of competition in a market can influence how taxes are distributed between producers and consumers

• Product characteristics: The nature of the good or service being taxed can affect its elasticity and thus the tax incidence

Policy design

• Tax rate: Higher tax rates can lead to greater distortions in market behavior and affect the distribution of the tax burden

• Tax base: The choice of what to tax (e.g., income, consumption, property) influences who ultimately bears the burden

• Exemptions and deductions: Specific tax policies, like food exemptions from sales tax, can alter the distribution of the tax burden

Examples of tax incidence

Corporate tax

• Worker impact: A study of German municipalities found that workers bear slightly more than half of the corporate tax burden, with low-skilled, women, and young workers most affected

• Consumer prices: A 1 percentage-point increase in corporate tax rate can lead to a 0.17% increase in retail prices, with stronger effects on lower-priced goods

• Firm characteristics: Small and medium-sized firms, which account for nearly 95% of all firms in Germany, respond most strongly to corporate tax changes

Sales tax

• Regressivity: Sales taxes are often considered regressive as lower-income households spend a larger portion of their income on taxed goods

• Business purchases: Taxing business purchases can be more regressive than direct taxes

• Food exemptions: Exempting food from sales tax can reduce regressivity and increase progressivity

Economic implications

Income distribution

• Inequality impact: Major tax cuts for the rich in 18 OECD countries between 1965-2015 led to higher income inequality, increasing the top 1% share of pre-tax national income by 0.7 percentage points on average

• Progressive vs. regressive effects: The design of tax policies can significantly influence whether they have progressive or regressive effects on income distribution

• Redistributive potential: Income taxes with progressive rates are often used as a tool to reduce inequality or slow its growth

Economic growth

• Limited growth impact: The study by Hope and Limberg found no significant effect on economic growth or unemployment from major tax cuts for the rich

• Mixed evidence: Some studies suggest higher top marginal income tax rates and tax progressivity may adversely affect growth, while others find no significant association

• Efficiency considerations: Proponents of tax cuts argue they can boost economic performance through efficiency gains and removal of behavioral distortions