Relationship between price elasticity of demand and tax incidence

Tax incidence - Wikipedia

relationship between price elasticity of demand and tax incidence

Mar 17, The answer is that the relative burden of a tax on consumers versus producers corresponds to the relative price elasticity of demand versus. The burden of a tax - it's incidence - tends to fall more heavily on whichever side tax borne by the supplier (seller) by dividing the price elasticity of demand by. To better see how the elasticity of supply and demand affects tax incidence, A typical demand or supply curve shows the relation between the price and the.

The tax incidence depends on the relative price elasticity of supply and demand. When supply is more elastic than demand, buyers bear most of the tax burden. When demand is more elastic than supply, producers bear most of the cost of the tax.

Tax revenue is larger the more inelastic the demand and supply are. The burden of tax Depending on the circumstance, the burden of tax can fall more on consumers or on producers. In the case of cigarettes, for example, demand is inelastic—because cigarettes are an addictive substance—and taxes are mainly passed along to consumers in the form of higher prices.

The analysis, or manner, of how the burden of a tax is divided between consumers and producers is called tax incidence.

How to calculate Excise Tax and determine Who Bears the Burden of the Tax

Elasticity and tax incidence Typically, the incidence, or burden, of a tax falls both on the consumers and producers of the taxed good. But if we want to predict which group will bear most of the burden, all we need to do is examine the elasticity of demand and supply. But how the tax incidence, or tax burden, is shared between buyer and seller depends on the elasticity of both demand and supply.

The buyer bears a greater portion of the tax burden when either demand is inelastic or supply is elastic, as depicted in diagrams 1 and 4, respectively. When demand is elastic or supply is inelastic, then the seller bears the major portion of the tax, as depicted in diagrams 2 and 3, respectively. The above diagrams shows how the tax incidence on buyer and seller is apportioned by a tax assessed on the seller by showing it as a shift in the supply curve caused by the tax.

EconPort - Elasticity and the Incidence of a Tax

A similar argument can be made for a tax on the buyer. Some have argued that these shifts in the curves occur because the quantity supplied or demanded is less with the tax than without it.

relationship between price elasticity of demand and tax incidence

A typical demand or supply curve shows the relation between the price and the quantity either demanded or supplied. The market equilibrium is where the 2 curves intersect. Any change in price results in a shift along the demand or supply curve. However, if demand or supply changes because of changes in other demand or supply determinantsthen there is a shift in the demand or supply curve, where the quantity differs for every price point.

Some have argued that, with the buyer's tax, there is a shift in the demand curve because the buyer buys less at each price.

Elasticity and the Incidence of a Tax

However, the traditional demand-supply diagram simply relates how quantities change in relation to the price — regardless of the reason for the change in price. The demand depends only on the price, not on who gets the money. Likewise, for sellers, the quantity supplied depends on the price that they receive — that the buyer pays a higher price makes no difference to them.

They supply according to the schedule of the prices that they actually receive.

Effect of tax – depending on elasticity

Some people have argued that to determine the tax incidence of a tax, one must first decide whether the demand curve or the supply curve has shifted, then find a new market equilibrium.

However, I believe that this unnecessarily complicates the analysis. A tax does not shift either the demand or the supply curve at all. In the traditional supply-demand diagram, there is a tacit assumption that the seller receives what the buyer pays. However, the imposition of the tax means that the buyer will pay more than what the seller receives — the difference goes to the government.

Therefore, the demand and supply curve do not, in actuality, intersect. Instead, there are 2 new equilibria — the buyer's equilibrium price and the seller's equilibrium price. The tax incidence can still be measured by the elasticities of demand and supply, but it is unnecessary to shift either curve. As can be seen in the graphs below, how the tax burden between buyer and seller varies with the elasticity of demand and supply can be shown without shifting either the demand or supply curve.

In graph 1, buyer and seller share the tax burden equally, since their elasticities are unitary. In graph 2, demand is elastic but supply is inelastic, causing most of the tax burden to fall on the seller. In graph 3, demand is inelastic but supply is elastic, causing the tax burden to fall mostly on the buyer. Generally, because sales taxes are assessed on many items, buyers bear most of the burden of sales taxes, since there are few other things that they can buy that are tax-free.

On the other hand, excise taxes, which are sales taxes on particular products, would, in many circumstances, hurt the sellers more because buyers can buy untaxed goods.

Elasticity and tax revenue (article) | Khan Academy

This elastic demand pushes the tax burden on the sellers. This is known as back shifting.

relationship between price elasticity of demand and tax incidence

Elastic supply, inelastic demand[ edit ] If, in contrast to the previous example, the consumer is perfectly inelastic, they will demand the same quantity no matter the price. Because the producer is elastic, the producer is very sensitive to price. A small drop in price leads to a large drop in the quantity produced. Because the consumer is inelastic, the quantity doesn't change much. Because the consumer is inelastic and the producer is elastic, the price changes dramatically.

The change in price is very large. The producer is able to pass in the short run almost the entire value of the tax onto the consumer. Even though the tax is being collected from the producer the consumer is bearing the tax burden.

The tax incidence is falling on the consumer, known as forward shifting. Similarly elastic supply and demand[ edit ] Most markets fall between these two extremes, and ultimately the incidence of tax is shared between producers and consumers in varying proportions. In this example, the consumers pay more than the producers, but not all of the tax.

The area paid by consumers is obvious as the change in equilibrium price between P without tax and 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. Inelastic supply, elastic demand: Although legislators might be seeking to tax the apple industry, in reality it could turn out to be truck drivers who are hardest hit, if apple companies shift toward shipping by rail in response to their new cost.

Or perhaps orange manufacturers will be the group most affected, if consumers decide to forgo oranges to maintain their previous level of apples at the now higher price. Ultimately, the burden of the tax falls on people—the owners, customers, or workers. If the tax proceeds are employed in a manner that benefits owners more than producers and consumers then the burden of the tax will fall on producers and consumers. If the proceeds of the tax are used in a way that benefits producers and consumers, then owners suffer the tax burden.

These are class distinctions concerning the distribution of costs and are not addressed in current tax incidence models.

relationship between price elasticity of demand and tax incidence

The US military offers major benefit to owners who produce offshore. Yet the tax levy to support this effort falls primarily on American producers and consumers. Corporations simply move out of the tax jurisdiction but still receive the property rights enforcement that is the mainstay of their income.

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