Tax Incidence

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In economics, tax incidence is the analysis of the effect of a particular tax on the distribution of economic welfare. Tax incidence is said to “fall” upon the group that ultimately bears the burden of, or ultimately has to pay, the tax. The key concept is that the tax incidence or tax burden does not depend on where the revenue is collected, but on the price elasticity of demand and price elasticity of supply. The concept was brought to attention by the French Physiocrats who believed that the incidence of all taxation falls ultimately on landowners and merely reduces land rent. For this reason they advocated the replacement of all the multiplicity of contemporary taxes by a land tax called the Impôt Unique to simplify taxation. Physiocrats were wrong about the incidence of taxes. Even though some of the incidence of sales taxes and income taxes falls upon land values indirectly, some burden also falls on consumers and workers.  Only the tax incidence of land value tax falls entirely on landlords which was why the Georgists later created a similar proposal, the ‘Single-Tax’ on land value.

The theory of tax incidence has a number of practical results. For example, half of the United States Social Security payroll taxes are legally paid by the employee and half by the employer. However, some economists think that the worker is bearing almost the entire burden of the tax because the employer passes the tax on in the form of lower wages. The tax incidence is thus said to fall on the employee.^[3] This is because the labor supply is to be inelastic compared with the labor demand.

Inelastic supply, elastic demand

Because the producer (worker) is inelastic, he will produce about the same quantity no matter what the price. Because the consumer (employer) is elastic, the consumer (employer) is very sensitive to price. A small increase in price leads to a large drop in the quantity demanded. The imposition of the tax causes the market price to increase from P^{without tax} to P^{with tax} and the quantity demanded to fall from Q^{without tax} to Q^{with tax}. Because the consumer (employer) is elastic, the quantity change is significant. Because the producer (worker) is inelastic, the price doesn’t change much. The producer (worker) pays the entire tax payment to the government which shifts the supply curve upward by the amount of the tax.  Only a small amount of the tax burden is shifted onto the consumer (employer) by forcing them to pay higher prices and the majority of the tax incidence falls on the producer (worker).

Elasticity of supply > Elasticity of demand

Ultimately the incidence of tax is shared between producers and consumers in varying proportions with the greater burden falling on the party with less elastic demand. In the following example, the consumers pay more than the producers because supply is a bit more elastic than demand. The area paid by consumers is obvious as the change in equilibrium price (between P^{without tax} to P^{with tax}); the remainder, being the difference between the new price and the cost of production at that quantity, is paid by the producers.

Reduced economic welfare

Most taxes have side effects that reduce economic welfare, either by mandating unproductive labor (compliance costs) or by creating distortions to economic incentives (deadweight loss and perverse incentives).

Cost of compliance

Although governments must spend money on tax collection activities, some of the costs, particularly for keeping records and filling out forms, are borne by businesses and by private individuals. These are collectively called costs of compliance. More complex tax systems tend to have higher compliance costs. This fact can be used as the basis for practical or moral arguments in favor of tax simplification (such as the FairTax or OneTax, and some flat tax proposals).  These tax “simplification” proposals also propose to dramatically change the incidence of taxation.  The FairTax would dramatically raise the tax burden for the poor and middle class and reduce it for the rich.  The OneTax would do the reverse.  Flat tax proposals can have dramatically different effects upon the burden of taxation.  Whereas the proponents of the FairTax downplayed the fact that their proposal would raise taxes for the vast majority of Americans, the OneTax was proposed by some of the Occupy Wall Street activists specifically because they want to cut taxes for most people among the bottom 98% of Americans.

Deadweight costs of taxation

In the absence of negative externalities, the introduction of taxes into a market reduces economic efficiency by causing deadweight loss. In a competitive market the price of a particular economic good adjusts to ensure that all trades which benefit both the buyer and the seller of a good occur. The introduction of a tax causes the price received by the seller to be less than the cost to the buyer by the amount of the tax. This causes fewer transactions to occur, which reduces economic welfare; the individuals or businesses involved are less well off than before the tax. The tax burden and the amount of deadweight cost is dependent on the elasticity of supply and demand for the good taxed.

Most taxes—including income tax and sales tax—can have significant deadweight costs. There are only a few ways to avoid deadweight costs of taxation.  One is to refrain from taxes that change economic incentives. Such taxes include the land value tax,^[44] where the tax is on a good in completely inelastic supply, a lump sum tax such as a poll tax (head tax) which is paid by all adults regardless of their choices. Arguably a windfall profits tax which is entirely unanticipated can also fall into this category.  The other way is to rely upon Pigouvian taxes that reduce negative externalities.

Deadweight loss can also be mitigated by the effect taxes have in leveling the business playing field. Business that have more money are better suited to fend off competition. It is common that an industry having a few but very large corporations have a very high barrier of entry of new entrants in the marketplace. This is due to the fact that the larger the corporation the better the position of it to negotiate with suppliers. Also the financial position can provide the means for the company to be able to operate for extended periods of time with very low or negative profits, in order to push the competition out of business. The taxation of profits in a progressive manner would reduce the barriers for entry in a specific market for new entrants thereby increasing competition. This would ultimately benefit the consumers since increased competition benefits consumers.^[45]

Perverse incentives

Complexity of the tax code in developed economies offer perverse tax incentives. The more details of tax policy there are, the more opportunities for legal tax avoidance and illegal tax evasion. These not only result in lost revenue, but involve additional costs: for instance, payments made for tax advice are essentially deadweight costs because they add no wealth to the economy. Perverse incentives also occur because of non-taxable ‘hidden’ transactions; for instance, a sale from one company to another might be liable for sales tax, but if the same goods were shipped from one branch of a corporation to another, no tax would be payable.

To address these issues, economists often suggest simple and transparent tax structures which avoid providing loopholes. Sales tax, for instance, can be replaced with a value added tax which disregards intermediate transactions.