Tax Incidence: Definition, Example, and How It Works

What Is a Tax Incidence?

Tax incidence (or incidence of tax) is an economic term for understanding the division of a tax burden between stakeholders, such as buyers and sellers or producers and consumers. Tax incidence can also be related to the price elasticity of supply and demand. When supply is more elastic than demand, the tax burden falls on the buyers. If demand is more elastic than supply, producers will bear the cost of the tax.

How a Tax Incidence Works

The tax incidence depicts the distribution of tax obligations, which must be covered by the buyer and seller. The level at which each party participates in covering the obligation shifts based on the associated price elasticity of the product or service in question as well as how the product or service is currently affected by the principles of supply and demand.

Tax incidence also reveals which group—consumers or producers—will pay the price of a new tax. For example, the demand for prescription drugs is relatively inelastic. That means that despite changes in cost, its market will remain relatively constant.

Levying New Taxes on Inelastic and Elastic Goods

Another example: The demand for cigarettes is mostly inelastic. When governments impose a cigarette tax, producers increase the sale price by the full amount of the tax, transferring the tax burden to consumers. Through analysis, it's been found that the demand for cigarettes is unaffected by price. Of course, there are limits to this theory. If a pack of cigarettes suddenly increased from $5 to $1,000, consumer demand would fall.

If the levying of new taxes on an elastic good, such as fine jewelry, occurs, most of the burden would likely shift to the producer as an increase in price may have a significant impact on the demand for the associated goods. Elastic goods are goods that have close substitutes or that are nonessential.

Price Elasticity and Tax Incidence

Price elasticity is a representation of how buyer activity changes in response to movements in the price of a good or service. In situations where the buyer is likely to continue purchasing a good or service regardless of a price change, the demand is said to be inelastic. When the price of the good or service profoundly impacts the level of demand, the demand is considered highly elastic.

Examples of inelastic goods or services can include gasoline and prescription medicines, as noted above. The level of consumption across the economy remains steady with price changes. Elastic products are those whose demand is significantly affected by price. This group of products includes luxury goods, houses, and clothing.

The formula for determining the consumer's tax burden, with "E" representing elasticity, is as follows:

• E (supply) / (E (demand)) + E (supply)

The formula for determining the producer or supplier's tax burden, with "E" representing elasticity, is as follows:

• E (demand) / (E (demand) + E (supply))

The Bottom Line

Tax incidence is a measure of the tax burden between producers and consumers or between different groups in an economy. Elasticity, which measure the relationship between prices and the demand for goods, is an element that helps determine tax incidence. Inelastic goods are those that consumers will continue to buy, even as the price goes up—for example, gasoline and prescription drugs. By contrast, with elastic goods, like a new home, car, or fashion, consumer demand will drop as prices rise. The tax burden shifts with inelastic vs. elastic goods.

Tax incidence also can be used to determine the fairness of a taxation system by contrasting the tax burden across a population. For example, using tax data from 2019, Connecticut issued a report in 2022 finding that its state and local tax system is unfair and regressive since working- and middle-class families pay a higher percentage of their income in taxes than upper-class families and the wealthy. Connecticut had come to the same conclusion in 2014, using tax data from 2011.