Tax Incidence

Key takeaways

• Tax incidence describes who legally pays a tax and who ultimately bears its economic burden.
• The division of burden between buyers and sellers depends mainly on the price elasticity of supply and demand.
• Taxes on inelastic goods tend to be borne by consumers; taxes on elastic goods tend to fall more on producers.
• Incidence analysis helps assess fairness and distributional effects (for example, whether a tax system is regressive).

What is tax incidence?

Tax incidence is the study of who ultimately bears the cost of a tax. There are two dimensions:
* Legal incidence — who is legally required to remit the tax to the government (e.g., sellers, employers).
* Economic incidence — who actually bears the economic burden after markets adjust (reflected in prices, wages, or returns).

How tax incidence works

When a tax is imposed, market prices and quantities adjust. The final burden—that is, how much of the tax is absorbed by buyers versus sellers—depends on how responsive supply and demand are to price changes.

If demand is relatively inelastic (buyers are not very price-sensitive), buyers will absorb most of the tax through higher prices. If supply is relatively inelastic (sellers are not very price-sensitive), sellers will absorb more of the tax through lower net prices received.

Price elasticity and the tax burden

Price elasticity measures how much quantity demanded or supplied changes in response to price changes.

• Inelastic demand: quantity changes little when price changes (e.g., essential medicines, gasoline). Taxes on such goods are largely passed on to consumers.
• Elastic demand: quantity changes a lot when price changes (e.g., luxury items, nonessential goods). Taxes on such goods are more likely absorbed by producers.

Formulas (elasticity-based)
* Consumer tax burden = E(supply) / [E(demand) + E(supply)]
* Producer tax burden = E(demand) / [E(demand) + E(supply)]

Here E(demand) and E(supply) are the price elasticities (absolute values). The larger the elasticity of one side, the smaller its share of the burden.

Illustrative examples

• Cigarettes: Demand is largely inelastic, so when a cigarette tax is imposed, much of the tax is passed on to consumers via higher retail prices.
• Prescription drugs: Demand tends to be inelastic; taxes and price changes often fall on consumers, raising concerns about affordability.
• Fine jewelry or luxury goods: Demand is relatively elastic, so producers may absorb more of a tax because higher prices significantly reduce sales.

Economic and distributional implications

• Revenue vs. equity: Taxing inelastic goods can raise revenue efficiently because quantity declines little, but it can be regressive—lower-income households may pay a larger share of income on such taxes.
• Market effects: Taxes can reduce consumption or production, shift market shares, and affect employment in taxed industries.
• Policy design: Understanding incidence helps policymakers target taxes, design exemptions, or provide compensating transfers to reduce undue burdens on vulnerable groups.

Common questions

Q: Does the person who writes the check to the government always bear the tax?
A: No. Legal remittance and economic burden differ. Markets typically shift the burden between buyers and sellers.

Q: Who is more affected, consumers or retailers?
A: It depends on elasticities. If consumers are insensitive to price changes, they will bear more. If they are sensitive, producers/retailers will bear more through lower net prices or reduced sales.

Bottom line

Tax incidence explains who ultimately pays a tax after market adjustments. Elasticities of supply and demand determine how the tax burden is shared. Policymakers must consider both efficiency and equity: taxing inelastic necessities raises revenue effectively but can impose disproportionate burdens on low‑income households.