Economic incidence

What Is Economic Incidence?

Economic incidence refers to the study of who ultimately bears the burden of a tax or the benefit of a subsidy, regardless of who is legally required to pay or receive it. This concept is a fundamental aspect of public finance, a branch of economics that analyzes government revenue and expenditure. Unlike statutory incidence, which indicates who is legally obligated to remit the tax to the government, economic incidence determines the actual distribution of the financial impact among different economic agents, such as consumers, producers, or workers⁵⁴, ⁵⁵. Understanding economic incidence is crucial because taxes, even if levied on one party, often lead to changes in market equilibrium, shifting a portion of the burden to others through altered prices or wages⁵¹, ⁵², ⁵³.

History and Origin

The concept of economic incidence has roots in early economic thought, with discussions dating back to the 18th-century French Physiocrats, notably François Quesnay. Quesnay argued that all taxation ultimately fell upon landowners, a view that highlighted the distinction between legal and true economic burdens. Over centuries, economists including Adam Smith and David Ricardo further explored how the burden of taxation is distributed.

A pivotal development in the modern understanding of economic incidence came with Richard Musgrave's The Theory of Public Finance, published in 1959. This seminal work applied the analytical tools of price theory and Keynesian macroeconomics to systematically examine tax incidence, economic efficiency, and full employment, transforming public finance into a more analytical discipline.⁴⁹, ⁵⁰ Musgrave's insights cemented the understanding that the actual burden of a tax is determined by market forces, especially the responsiveness of supply and demand, rather than simply by who writes the check to the government.

Key Takeaways

• Economic incidence reveals who truly pays for a tax or benefits from a subsidy after market adjustments.
• It differs from statutory incidence, which is the legal obligation to pay the tax.
• The relative elasticity of demand and supply is the primary determinant of economic incidence.
• Taxes create a "wedge" between the price consumers pay and the price producers receive, affecting both parties.
• Understanding economic incidence is vital for policymakers to design equitable and efficient tax systems.

Formula and Calculation

The economic incidence of a tax is determined by the relative price elasticities of demand and supply. While there isn't a single universal formula for overall economic incidence, the share of a tax borne by consumers or producers in a specific market can be approximated using the following relationship for a specific (unit) tax:

Where:

• (E_S) = Price elasticity of supply (always positive)
• (|E_D|) = Absolute value of the price elasticity of demand (always positive for calculation of burden share, as demand elasticity is typically negative)

This formula shows that the more inelastic side of the market bears a greater share of the tax burden.⁴⁵, ⁴⁶, ⁴⁷, ⁴⁸ For example, if demand is perfectly inelastic ($|E_D| = 0$), consumers bear the entire burden. If supply is perfectly inelastic ($E_S = 0$), producers bear the entire burden.

Interpreting Economic Incidence

Interpreting economic incidence requires analyzing how a tax alters the equilibrium price and quantity in a market. When a tax is imposed, it drives a wedge between the price consumers pay and the price producers receive. The side of the market that is less responsive to price changes—i.e., less elastic—will bear a larger portion of the tax burden.

For instance, if consumers have many substitutes for a product, their demand is elastic. A tax on this product would likely result in producers bearing a larger share of the burden, as consumers would easily switch to alternatives if the price rose significantly. Conversely, if a product has few substitutes, consumer demand is inelastic. In this scenario, consumers would bear most of the tax, as they are less able to reduce their consumption in response to a price increase. Ana⁴², ⁴³, ⁴⁴lyzing economic incidence helps economists and policymakers understand the true distributional effects of fiscal policies, going beyond who is legally responsible for the tax payment.

Hypothetical Example

Consider a hypothetical market for a popular brand of artisanal coffee, "Morning Bliss," where a new $0.50 per cup excise tax is imposed on coffee shops (producers).

1. Initial State: Before the tax, the equilibrium price is $4.00 per cup, and 1,000 cups are sold daily.
2. Tax Imposition: The government levies a $0.50 tax on coffee shops for each cup sold.
3. Market Adjustment:
   • The coffee shops will attempt to pass on some of this tax to consumers by raising prices.
   • However, consumers might be sensitive to price increases and reduce their demand, perhaps by switching to another coffee shop or drinking less coffee.
   • Let's assume the new equilibrium price consumers pay rises to $4.35 per cup, and the quantity sold falls to 900 cups.
4. Calculating Economic Incidence:
   • Consumer Burden: Consumers now pay $4.35 per cup, an increase of $0.35 from the original $4.00. This $0.35 is the portion of the $0.50 tax borne by consumers.
   • Producer Burden: Producers receive $4.35 from consumers but must remit $0.50 to the government, meaning they effectively receive $3.85 per cup ($4.35 - $0.50). This is a $0.15 reduction from their original $4.00 per cup. This $0.15 is the portion of the $0.50 tax borne by producers.

In this example, consumers bear a larger share ($0.35) of the $0.50 tax than producers ($0.15). This indicates that the demand for "Morning Bliss" coffee is relatively less elastic than the supply in this specific market, meaning consumers are less responsive to price changes compared to producers' ability to adjust production.

Practical Applications

Economic incidence analysis is a vital tool in various real-world scenarios, particularly within government policy and market analysis:

• Tax Policy Design: Governments use economic incidence to understand the distributional effects of proposed taxes. For example, analyzing the incidence of a sales tax can reveal if it disproportionately affects lower-income households, making it a regressive taxation policy. Conversely, understanding the incidence of progressive taxation like income tax helps determine if higher earners truly bear a larger share of the burden, thus impacting income inequality. The⁴⁰, ⁴¹ Congressional Budget Office's 2019 report on household income and federal taxes illustrates these distributional effects across different income quintiles.
• ³⁹ Labor Market Analysis: When social security taxes or employer-mandated benefits are introduced, economic incidence helps determine whether the burden falls on employers (through higher labor costs) or employees (through lower wages or reduced benefits). Many economists argue that workers bear a significant portion of payroll taxes despite employers nominally paying half.
• Corporate Taxation: The incidence of corporate income tax is complex. While legally levied on corporations, the economic burden can be shifted to shareholders (through lower dividends), workers (through lower wages), or consumers (through higher prices). Studies on corporate tax incidence often debate the ultimate bearer of this burden.
• ³⁸ Environmental and "Sin" Taxes: Governments impose excise taxes on goods like tobacco, alcohol, or carbon emissions to discourage consumption. Economic incidence helps assess how much of these taxes is passed on to consumers versus absorbed by producers, influencing the effectiveness of the tax in changing behavior and its impact on different income groups.
• International Tax Reforms: Global initiatives, such as the OECD's efforts to reform international corporate taxation, consider economic incidence to ensure fair distribution of tax revenues among countries and to prevent tax avoidance. The³⁵, ³⁶, ³⁷ OECD's Tax Policy Reforms 2023 publication details how various jurisdictions are adapting their tax policies.

##³⁴ Limitations and Criticisms

While economic incidence analysis provides crucial insights into who truly bears the financial burden of taxes or benefits from subsidies, it is not without limitations and criticisms.

One primary challenge lies in the assumptions underlying many economic models. For instance, models often assume perfectly competitive markets or rational behavior, which may not always hold true in the complex real world. The³³ presence of market rigidities, such as minimum wage laws or price controls, can complicate the shifting of tax burdens and alter standard incidence outcomes.

Fu³²rthermore, reliably estimating economic incidence requires high-quality data, which is not always available or can be difficult to collect. Dyn³¹amic effects, which involve long-term behavioral responses and adjustments in capital stock or labor supply, are also challenging to model accurately. For example, a capital income taxation might initially appear to burden capital owners, but in the long run, it could reduce savings and investment, potentially lowering wages for workers if the capital stock declines.

Cr²⁸, ²⁹, ³⁰itics also point out that the analysis often focuses on specific markets (partial equilibrium) and may not fully capture broader, economy-wide impacts (general equilibrium). A t²⁶, ²⁷ax in one market might have ripple effects, influencing prices and consumption in related or substitute markets. Add²⁴, ²⁵itionally, empirical studies on economic incidence can yield varying estimates due to different methodologies, assumptions, and the specific context being analyzed. The Brookings Institution analysis of the Tax Cuts and Jobs Act, for instance, highlights how claims about tax cuts "paying for themselves" often do not materialize, demonstrating the complexity of predicting actual revenue and economic outcomes.

##²³ Economic Incidence vs. Statutory Incidence

Economic incidence and statutory incidence are two distinct but related concepts in public finance. The key difference lies in who is legally responsible for paying a tax versus who ultimately bears the financial burden of that tax.

Statutory Incidence refers to the party or entity that is legally obligated to remit the tax payment to the government. For²⁰, ²¹, ²² example, a sales tax might be legally imposed on the retailer, meaning the retailer is responsible for collecting the tax from customers and sending it to the tax authority. Similarly, an employer is legally responsible for paying the employer's share of payroll taxes. This is a matter of law and accounting.

Economic Incidence, on the other hand, describes the true distribution of the tax burden after market adjustments have occurred. Eve¹⁸, ¹⁹n if a retailer is legally required to pay a sales tax, they might pass a portion (or even all) of that tax onto consumers through higher prices. Conversely, if demand is very sensitive to price, the retailer might absorb much of the tax by accepting lower profit margins to maintain sales volume. Therefore, the economic incidence can be on consumers, producers, or shared between them, regardless of who is legally designated to pay. The critical insight of economic incidence is that the party legally responsible for the tax does not necessarily bear its full financial impact.

##¹⁴, ¹⁵, ¹⁶, ¹⁷ FAQs

What factors determine economic incidence?

The primary factors determining economic incidence are the relative price elasticity of demand and supply for the taxed good or service. The side of the market that is less elastic (less responsive to price changes) will bear a greater portion of the tax burden.

##¹⁰, ¹¹, ¹², ¹³# Why is economic incidence important for policymakers?
Economic incidence is crucial for policymakers because it helps them understand the true distributive effects of tax policies. It allows them to see who actually pays the tax, which is vital for achieving goals related to income inequality, fairness, and economic efficiency, rather than just knowing who is legally required to submit the tax.

##⁷, ⁸, ⁹# Can a tax burden be shifted entirely to consumers or producers?
Yes, in extreme cases of perfect elasticity, the entire tax burden can be shifted. If demand is perfectly inelastic (consumers buy the same quantity regardless of price), consumers bear the entire burden. If supply is perfectly inelastic (producers supply the same quantity regardless of price), producers bear the entire burden. Similarly, if demand is perfectly elastic or supply is perfectly elastic, the entire burden can fall on the other side of the market. How⁵, ⁶ever, such perfect elasticities are rare in real markets.

What is the difference between direct and indirect taxes in terms of incidence?

Historically, direct taxes (like income tax) were thought to have incidence on the payer, while indirect taxes (like sales tax) were believed to be shifted to consumers. However, modern economic incidence analysis shows that both direct and indirect taxes can be shifted. For example, while income tax is direct, its effects on labor supply and investment can lead to broader economic incidence. The⁴ legal classification (direct vs. indirect) does not dictate the economic incidence.

Does a tax always lead to a deadweight loss?

Generally, yes. A tax creates a "wedge" between the price paid by consumers and the price received by producers, which typically reduces the quantity of goods or services exchanged in the market below the efficient level. This reduction in mutually beneficial transactions leads to a deadweight loss, representing a loss of overall economic welfare. How¹, ², ³ever, the magnitude of this loss depends on the elasticities of supply and demand.