Sessions 03_Incidence of Taxes

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Course No. 4135:Course No. 4135:

K e y W o r d s / O u t l i n e

TaxationTaxation

Incidence of TaxesIncidence of Taxes



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Issues to be discussed:Issues to be discussed:

Impact, Incidence and Effect of a Tax

Shifting of Tax Incidence

Theories of Tax Shifting

Factors Influencing Tax Shifting

General Effects of Taxation



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Impact, Incidence and Effect of TaxImpact, Incidence and Effect of Tax

Impact of a Tax: Impact of a tax is its first point of contact with thetaxpayers. It is upon those who bear the first responsibility of paying it to the authorities, that is those have statutoryresponsibility of paying it to the Government.

Incidence of a Tax: Incidence of a tax is defined as its final resting place. It is to be seen and judged in terms of money burden of the

tax. To put it differently, the incidence of a tax is upon thoseeconomic units which finally bear the money burden of it and whichare not able to pass it on to others. Incidence lies upon that finalsource from which tax money comes.

Effect of a Tax: When a tax is imposed and collected, it involvescertain responses from taxpayers and the economy. Suchresponses can be of great variety and can profoundly influence the

working of the economy in terms of production, growth, savings,investment, choice of techniques of production, regionalimbalances, inequalities of income and wealth, and so on. Theseresponses and their results are collectively called the effects of that tax . These effects can be the result of the fact of tax imposition itself and they could also follow from the process of shifting its incidence.Effects of a tax can be both beneficial and harmful. Harmful effects

of a tax will be referred to as the burden of that tax .



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Burden of a Tax: Money burden/formal incidence: reduction in the disposable

income of the taxpayers

Direct money burden – amount of tax being paid by thetaxpayers to the tax authorities

Indirect money burden – additional money expensesincurred by the taxpayers for tax payment

Real Burden: loss of welfare to the taxpayers and thecommunity as a whole, in terms of increasingunemployment, reduced production, etc.

Direct real burden – sacrifice of the welfare which the tax itself imposes upon the taxpayers, but not as net of the benefits, if any

Indirect money burden – indirect loss of welfare which resultsfrom (a) interference with consumer choice, (b) changes in factor supply and hence total output, and (c) changes in employment through changes in aggregate demand



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Impact vs. Incidence: The impact refers to the initial bearing of the tax while incidence refers to the

ultimate bearing of the tax.

Impact is felt by the taxpayer at the point of imposition of the tax, while theincidence is felt by the taxpayer at the point of settlement or rest of the tax.

The impact of the tax is felt by the person from whom the tax is collected,while the incidence is felt by the person who actually bears the tax liability.

Impact of a tax can be shifted, but the incidence of a tax cannot be shifted.

Incidence vs. Effect: A tax reduces the income of the person on whom the incidence rests, while

the effect of the tax is the pressure or influence of the incidence (such as

forced reduction of consumption and investment for disposable income

reduced by tax incidence).

The incidence of a tax is the direct money burden, and the effect of the tax is

the indirect money burden.

The effects of a tax can be the result of the fact of tax imposition itself

( impact ) and they could also follow from the process of shifting its incidence.



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Shifting of Tax IncidenceShifting of Tax Incidence

Shifting of tax incidence refers to the process by which the money burdenof a tax is transferred from one person to another. Shifting of tax incidenceis done through the means of a price variation.

Forward shifting: If a tax incidence is shifted through a sales transaction, it is called forward shifting . For example, an excise duty imposed on a producer may be shifted to a consumer, or a value added tax (VAT)imposed on a seller may be shifted to a buyer. In case of multi-stage

forward shifting of tax incidence, a tax incidence shifted from a seller to anintermediate purchaser who will also shift it to another buyer and so on until the tax finally settles on the ultimate purchaser or consumer, it may becalled that the tax is being shifted onward .

Backward shifting: If a tax incidence is shifted through a purchasetransaction, it is called backward shifting . If a VAT imposed on a consumer and he can shift it to the producer, or a VAT imposed on a buyer and he can

shift it to the seller, then it will be backward shifting. Backward shifting may be through tax capitalization, when a tax affects the capital value of assets.If a tax changes the expected yield of an asset, then it will also change itsmarket price. In other words, the tax has been capitalized. Say, a durablegood is subject to a periodic tax (e.g., equivalent to previous annual licencefee on TV) and an equivalent of the future tax payments is found in terms of the present value (PV) of the periodic tax discounted on the basis of interest

rate. If the purchase price of the durable item is reduced by a part or full amount of this PV by the purchaser, then it is called tax capitalization.



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Shifting of Tax IncidenceShifting of Tax Incidence

Theories of Tax Shifting Concentration Theory: This approach maintains that there

is an inherent tendency for the taxes to be absorbed bycertain income classes (e.g., tax on wage or tax on landincome only).

Diffusion Theory: This theory asserted that all taxes arediffused among the members of a community. Because of the constant interaction of sales/purchase transactions,eventually it becomes impossible to trace the finalincidence of any tax and in reality all taxes get “diffused” in the economic system.

Demand and Supply Theory: According to this theory, atax can be shifted only through a shift in the demandand/or supply curves and the sharing of the incidence willbe determined by the demand and supply elasticities.



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Demand and Supply Theory of Tax ShiftingDemand and Supply Theory of Tax Shifting

S1

©

S1

S

S©D1

D

D1

©

D

©

EC

A

P

©

M M

PB

SS1= tax PM= original price P © M ©= new price with tax

AM © = price received by seller P © A = tax taken by Govt.

P © B = tax borne by buyer BA = tax borne by seller

ed =(MM© /OM)/(P ©

B/PM)

O

es =(MM© /OM)/(BA/PM)

es /ed = P© B/BA

ed =elasticity of demand

es =elasticity of supply



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Demand and Supply Theory of Tax ShiftingDemand and Supply Theory of Tax Shifting

Thus, according to the demand and supply theory of tax shifting, tax incidence is

borne by buyer and seller as follows:

Buyer’s share of incidence

Seller’s share of incidence=

Elasticity of Supply (es)

Elasticity of Demand (ed)

Thus,• if ed = ∝ [Demand Curve parallel to X-axis] , es = 0 [SC parallel to Y-

axis] , the entire incidence of the tax is on the seller .• if es = ∝ [Supply Curve parallel to X-axis ] , ed = 0 [DC parallel to

Y-axis] , the entire incidence of the tax is on the buyer .

• if ed

= es

, the incidence of the tax is equally divided between theseller and the buyer.

• if es > ed, the incidence of the tax is in higher proportion upon the

buyer than upon the seller.• if ed > es, the incidence of the tax is in higher proportion upon the

seller than upon the buyer.



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Additional Factors Influencing Tax Shifting Additional Factors Influencing Tax Shifting

Main Factors Influencing Tax Shifting:• Elasticity of supply• Elasticity of demand

Additional Factors Influencing Tax Shifting:• Type of tax – transaction tax easier to shift• Price being fixed and accepted as normal – difficult to shift

through price variation• Tax rate – small tax chosen to be borne by the seller in a

competitive situation• Tax on commodity having close and effective substitute –

difficult to shift• Geographical coverage of a tax – if tax not imposed in

neghbouring areas, difficult to shift



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General Effects of TaxationGeneral Effects of Taxation

1. All tax measures would work through either influence on the demand

and the supply forces in the market.1. The tax measures either reduce the disposable income of the buyers

(individuals, firms and so on) and thereby affect their demand, or they

have an important bearing upon the economy through supply efforts of

taxation. Elasticity of supply (es) and elasticity of demand (ed) are the

major determinants in the detailed results of taxation.

1. On account of the shifting of incidence, both demand and supplyreactions may get mixed up leading to further rounds of effects, which

is called “announcement effects” (Pigou).

Effects of Taxation are the changes in the economy resulting from the

imposition of a tax system (or a variation in it). Usual working of tax

measures in a market economy:

Taxation policy should be as follows to optimum allocation of resources

at the equilibrium point where the “social indifference curve” is tangent

with the “production possibility curve”.



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Effect on Effects of Direct Tax Effects of Indirect Tax

Income Higher direct taxes reduce disposableincome by curtailing the incomedirectly. In the countries where

unemployment allowances are provided, the situation becomes worsewhen an unemployed getsemployment but falls in the lower income-bracket, because then he willnot receive the unemployment benefitand at the same time he has to pay tax.This is called ‘unemployment trap’.

Usually the imposition of an indirect tax increases the price of the concerned

goods or services. Thusthe purchaser has to paymore, which reduces thenet income.



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Savings andInvest-ment

Higher direct taxes reduce the abilityof the tax-paying individuals or enterprises to save or invest. But itdepends on the extent of financing the

enhanced tax from savings or consumption.

Usually it is said that higher indirect taxindirectly encourages savings, because itincreases price and thereby reducesdemand. But in the overall effect, higher

indirect taxation decreases savings andinvestments.

Price Higher direct taxes have a deflationaryeffect on price by decreasing thedemand. But labour organizations maycreate pressure to increase the wagelevel to meet the higher taxes, whichmay cause a cost-push inflationaryeffect.

Indirect taxation usually increases pricelevel and it has an inflationary effect. Butthe extent of inflationary effect dependson the price elasticities of demand andsupply. If the price elasticity of supply ismore than the price elasticity of demand,then the price will rise and if the priceelasticity of demand is higher, then the price will fall.



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Initiative Higher direct taxes have a negativeeffect on initiative, because then theleisure will be more preferable towork. But it is sometimes said, due to

higher direct tax some will do moreworks in order to maintain thestandard of living.

Higher indirect tax has also anegative effect on the businesscommunity’s initiative, becauseit is seen as an impediment to

their trade and commercecausing a price barrier.

OverallEconomy

Other things remaining the same, as a result of higher taxation,aggregate demand of the economy will fall, which may cause an

inflationary effect on the price and output levels. Balance of paymentsmay be improved by decreasing the dependency on foreign aid. Butthe employment situation may be worsen due to the fall in aggregatedemand. Besides, taxation may affect regional disparity, inequality

between income and wealth, etc.



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End of the PresentationEnd of the Presentation

Thank you.

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Sessions 03_Incidence of Taxes

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