A tax incidence is an economic concept that describes who ultimately pays the cost of a tax, beyond the actual fees. In other words, even if someone doesn’t directly pay a tax, they may feel its effects, such as paying higher prices.
Understanding tax incidence can help you gain a better grasp of the full effects of different taxes, particularly if you’re involved in policymaking.
Definition and Examples of Tax Incidence
A tax incidence is effectively the burden that a party, either an individual or business, ultimately bears, even if they’re not the ones directly paying a tax. For example, a sales tax on clothing would be paid directly by consumers at the time of purchase. A $100 purchase with a 5% sales tax would mean the consumer pays an additional $5. However, the tax incidence of the sales tax could fall on retailers if, say, it prompted consumers to purchase less clothing.
Maybe the consumer has a strict $100 budget, so, accounting for sales tax, they decide to leave out an item and purchase $80 worth of clothing, plus pay $4 in sales tax. In this scenario, the retailer arguably bears more of the tax burden, because the consumer is purchasing $20 less in merchandise.
In other instances, consumers might be affected by certain taxes more than retailers. Perhaps higher business taxes lead a store to raise prices, thereby causing consumers to feel the effect of those taxes more. That can particularly be the case if price elasticity—or the percentage change in quantity when a price changes by 1%—is a factor.
If something is a necessity, it could be inelastic, meaning consumers will still purchase the same amount, even if the price goes up. Yet if something is elastic (for example, a non-necessity like some consumer electronics) then consumers might decide to purchase less as the price goes up, meaning retailers might feel the incidence of higher business taxes.
Determining incidence isn’t always straightforward, as many variables can be at play. Perhaps there’s a mix of consumers and retailers carrying the burden of higher sales or business taxes, but tax incidence can also fall to employees. Maybe retailers drop wages or lay off staff in response to lower demand, meaning workers bear the brunt of the cost.
How Does Tax Incidence Work?
Tax incidence works by determining who ultimately bears the cost of a tax rather than looking at who pays the tax directly. Figuring out this burden isn’t necessarily easy. Economists can apply different types of models to try to determine tax incidence, but the answer may not be clear-cut, even for them—especially because multiple factors may be at play at once.
For example, a fall in consumer purchasing following a rise in sales taxes may be correlated, but perhaps the cause has more to do with broader economic conditions. In that case, the tax incidence might be overstated.
At other times, however, it may be possible to more narrowly isolate cause and effect in taxation. For instance, some jurisdictions have sales tax holidays, when there’s no sales tax on purchases below a given dollar amount for a short period.
In these cases, it may be possible to see how the lack of sales tax affects purchasing behavior, which can indicate who bears the cost of the tax. If retailers earn far more revenue during these sales-tax holidays, that could mean they’re shouldering at least some of the cost of normal sales taxes, rather than just the consumer who’s paying these fees. Still, the results can be somewhat muddled, as consumers may shift some normal purchasing from regular tax periods to sales-tax holidays.
What Does Tax Incidence Mean for Individuals?
Individuals, particularly those who have some sort of policymaking role, should consider tax incidence to get a more complete picture of the cost of adjusting taxes. You may be in favor of some taxes on paper, but when you look at who’s ultimately paying the cost, maybe you realize there are some unintended consequences. Instead, consider a tax that has a more direct incidence on the party who’s actually paying the tax upfront, which might seem more equitable.
If you’re not a policymaker, you can still consider tax incidence when making your voting choices.
Tax incidence can be relevant when engaging in policy issues, such as when you write your local congressional representative about one of their positions.
You also may want to consider tax incidence if you think a tax policy under consideration will end up having a significant unintended effect on someone who’s not directly being taxed.
- Tax incidence reflects who ultimately bears the cost of taxes, which isn’t always the person who pays them directly.
- Multiple parties can be affected by tax incidence. Consumers might pay higher sales taxes, but at the same time, retailers might feel the cost even more due to reduced sales, which can also result in lower employee pay.
- Economists don’t always agree on tax incidence. Establishing tax incidence isn’t always straightforward, as several factors may be involved. Economists can try to determine it by applying different types of models.