One of the more important things that distinguishes economists from non-economists is a familiarity with the notion of tax incidence. The statutory incidence of a tax (who sends the cheque to the Receiver-General?) is usually very different from its economic incidence (who is out of pocket?).
The basic intuition is simple enough. We all understand that if the government chooses to impose a tax on gasoline retailers of $0.50 per litre, customers can expect to see a similar increase in gas prices. Even if the statutory incidence falls on the sellers, the economic incidence is borne by the consumers.
The question of who ultimately bears the burden of the tax is almost entirely separate from the question of statutory incidence. (There's even a pejorative term - the 'flypaper theory' - for the claim that taxes stick to those who are first touched by it.) So what does determine the economic incidence of a tax?
The key determinant turns out to be the relative elasticities of demand and supply for the the good that is being taxed. If supply (demand) is inelastic, the quantity supplied (demanded) varies only slightly as the market price changes. The extreme case is an elasticity of zero, where the quantity supplied (demanded) is fixed, and the price is determined by the other side of the market. If supply (demand) is elastic, the quantity supplied (demanded) is very sensitive to changes in the market price. The extreme case is of infinite elasticity, where the quantity supplied (demanded) is indeterminate at a given price, and the quantity is determined by the other side of the market.
Let's look at the case where supply is relatively more elastic than demand. In terms of the standard graph of supply and demand, this means that the supply curve is relatively flat, while the demand curve is relatively steep. Suppose now that the government is considering a tax of τ:
- If the tax is levied on sellers, the supply curve shifts up by an amount equal to the tax, so that the after-tax supply curve remains the same.
- If the tax is levied on purchasers, the demand curve shifts down by an amount equal to the tax, so that the after-tax demand curve remains at the pre-tax level.
Here is a graph of the two cases:
In both graphs, the vertical axis is the selling price (the choice is arbitrary, and doesn't affect the conclusion). If the tax is paid on the supply side, the supply curve shifts from S0 to S1, the price increases from P0 to P1, and the quantity falls from Q0 to Q1. At Q1, the difference between the new selling price and the amount received by the supplier after taxes is τ, the amount of the tax.
The yellow region corresponds to the amount of taxes paid by the consumer (in the form of a higher selling price), and the green rectangle is the tax paid by the sellers (in the form of a lower after-tax price). Given the relative slopes of the supply and demand curves, the change in the selling price is almost as large as the tax itself, and almost all of the tax is ultimately borne by the consumer, even though the statutory incidence is on the supply side.
Suppose now that the tax is levied on those who purchase the good. In this case, the supply curve is unaffected, but since consumers must pay the tax on top of the selling price, the demand curve shifts down by an amount equal to the tax. The demand curve shifts from D0 to D1, the price decreases from P0 to P1, and the quantity falls from Q0 to Q1. At Q1, the difference between the new price and the amount paid by the consumer is τ. Once again, the green rectangle is the tax paid by the sellers, in the form of a lower selling price. The consumer benefits from this lower price but must still pay the tax, so the net payment is the yellow rectangle.
It should be clear by now that in terms of tax incidence, both graphs tell the same story. Since supply is relatively more elastic than demand, the burden of the tax falls relatively more on consumers, and relatively less on sellers. In the extreme cases of a perfectly inelastic (i.e., vertical) demand curve or a perfectly elastic (horizontal) supply curve, the entire burden is borne by the demand side regardless of where the tax is applied.
Now let's look at the case where demand is relatively more elastic than supply. The story is the same as above, but changing the slopes of the curves alters the relative sizes of the yellow and green rectangles:
Since demand is relatively more elastic than supply, the burden of the tax falls relatively more on sellers, and relatively less on consumers. In the extreme cases of a perfectly inelastic (vertical) supply curve or a perfectly elastic (horizontal) demand curve, the entire burden is borne by the supply side regardless of where the tax is applied.
Here are two cases where this distinction has important policy implications:
- Corporate taxes. I've gone through this point several times (most recently here) and I've compiled a reading list on the topic over here. If you assume that we are in a small open economy where capital flows freely, the supply of capital is relatively elastic. This corresponds to the first set of graphs, and so the result is that very little of the burden of corporate taxes falls on capitalists. Those who claim that owners of capital bear the entire burden are implicitly assuming - as did Harberger (1962) - that the supply of capital is perfectly inelastic. For large countries such as the US, the supply of capital is less than perfectly elastic, so the applicability of small open economy results can be problematic. But the empirical evidence for small open economies is pretty clear: the burden of corporate taxes falls mainly on workers.
- Payroll taxes. These include employer contributions to EI and C/QPP as well as Worker's Compensation premiums. But as a HRCD survey notes, long-run labour demand is more elastic than labour supply, so the ultimate effect of payroll taxes is to reduce wages: "labour's share of the payroll tax burden in the long run is in the range of 87 to 100 percent."
If you're concerned about distributional issues, then this is an important concept. It's a mistake to go from noting that the statutory incidence is on a certain group of people to concluding that these are also the same people who actually pay the tax. Unfortunately, it's also a common mistake.