Course No.

4135:

Taxation

Incidence of Taxes

Key Words / Outline

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Issues to be discussed:
Impact, Incidence and Effect of a Tax Shifting of Tax Incidence Theories of Tax Shifting Factors Influencing Tax Shifting General Effects of Taxation

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Impact, Incidence and Effect of Tax

Impact of a Tax: Impact of a tax is its first point of contact with the taxpayers. It is upon those who bear the first responsibility of paying it to the authorities, that is those have statutory responsibility of paying it to the Government. Incidence of a Tax: Incidence of a tax is defined as its final resting place. It is to be seen and judged in terms of money burden of the tax. To put it differently, the incidence of a tax is upon those economic units which finally bear the money burden of it and which are not able to pass it on to others. Incidence lies upon that final source from which tax money comes. Effect of a Tax: When a tax is imposed and collected, it involves certain responses from taxpayers and the economy. Such responses can be of great variety and can profoundly influence the working of the economy in terms of production, growth, savings, investment, choice of techniques of production, regional imbalances, inequalities of income and wealth, and so on. These responses and their results are collectively called the effects of that tax. These effects can be the result of the fact of tax imposition itself and they could also follow from the process of shifting its incidence. Effects of a tax can be both beneficial and harmful. Harmful effects of a tax will be referred to as the burden of that tax.

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Impact, Incidence and Effect of Tax

Burden of a Tax:
Money burden/formal incidence: reduction in the disposable
income of the taxpayers

Direct money burden amount of tax being paid by the taxpayers to the tax authorities Indirect money burden additional money expenses incurred by the taxpayers for tax payment Real Burden: loss of welfare to the taxpayers and the community as a whole, in terms of increasing unemployment, reduced production, etc. Direct real burden sacrifice of the welfare which the tax itself

imposes upon the taxpayers, but not as net of the benefits, if any Indirect money burden indirect loss of welfare which results from (a) interference with consumer choice, (b) changes in factor supply and hence total output, and (c) changes in employment through changes in aggregate demand

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Impact, Incidence and Effect of Tax

Impact vs. Incidence:
The impact refers to the initial bearing of the tax while incidence refers to the ultimate bearing of the tax. Impact is felt by the taxpayer at the point of imposition of the tax, while the incidence is felt by the taxpayer at the point of settlement or rest of the tax. The impact of the tax is felt by the person from whom the tax is collected, while the incidence is felt by the person who actually bears the tax liability. Impact of a tax can be shifted, but the incidence of a tax cannot be shifted.

Incidence vs. Effect:

A tax reduces the income of the person on whom the incidence rests, while the effect of the tax is the pressure or influence of the incidence (such as forced reduction of consumption and investment for disposable income reduced by tax incidence). The incidence of a tax is the direct money burden, and the effect of the tax is the indirect money burden. The effects of a tax can be the result of the fact of tax imposition itself (impact) and they could also follow from the process of shifting its incidence.

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Shifting of Tax Incidence

Shifting of tax incidence refers to the process by which the money burden of a tax is transferred from one person to another. Shifting of tax incidence is done through the means of a price variation. Forward shifting: If a tax incidence is shifted through a sales transaction, it is called forward shifting. For example, an excise duty imposed on a producer may be shifted to a consumer, or a value added tax (VAT) imposed on a seller may be shifted to a buyer. In case of multi-stage forward shifting of tax incidence, a tax incidence shifted from a seller to an intermediate purchaser who will also shift it to another buyer and so on until the tax finally settles on the ultimate purchaser or consumer, it may be called that the tax is being shifted onward. Backward shifting: If a tax incidence is shifted through a purchase transaction, it is called backward shifting. If a VAT imposed on a consumer and he can shift it to the producer, or a VAT imposed on a buyer and he can shift it to the seller, then it will be backward shifting. Backward shifting may be through tax capitalization, when a tax affects the capital value of assets. If a tax changes the expected yield of an asset, then it will also change its market price. In other words, the tax has been capitalized. Say, a durable good is subject to a periodic tax (e.g., equivalent to previous annual licence fee on TV) and an equivalent of the future tax payments is found in terms of the present value (PV) of the periodic tax discounted on the basis of interest rate. If the purchase price of the durable item is reduced by a part or full amount of this PV by the purchaser, then it is called tax capitalization.

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Shifting of Tax Incidence

Theories of Tax Shifting
Concentration Theory: This approach maintains that there is an inherent tendency for the taxes to be absorbed by certain income classes (e.g., tax on wage or tax on land income only). Diffusion Theory: This theory asserted that all taxes are diffused among the members of a community. Because of the constant interaction of sales/purchase transactions, eventually it becomes impossible to trace the final incidence of any tax and in reality all taxes get diffused in the economic system. Demand and Supply Theory: According to this theory, a tax can be shifted only through a shift in the demand and/or supply curves and the sharing of the incidence will be determined by the demand and supply elasticities.

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Demand and Supply Theory of Tax Shifting

SS1= tax PM= original price P M = new price with tax P A = tax taken by Govt. BA = tax borne by seller AM = price received by seller P B = tax borne by buyer

D D1 E C S1 S D1 O M M P B A P

S1 S

ed =elasticity of demand es =elasticity of supply ed =(MM /OM)/(P B/PM) es =(MM /OM)/(BA/PM) es /ed = P B/BA

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Demand and Supply Theory of Tax Shifting

Thus, according to the demand and supply theory of tax shifting, tax incidence is borne by buyer and seller as follows: Buyers share of incidence Elasticity of Supply (es) = Sellers share of incidence Elasticity of Demand (ed)

Thus, if ed = [Demand Curve parallel to X-axis], es = 0 [SC parallel to Yaxis], the entire incidence of the tax is on the seller. if es = [Supply Curve parallel to X-axis], ed = 0 [DC parallel to Y-axis], the entire incidence of the tax is on the buyer. if ed = es, the incidence of the tax is equally divided between the seller and the buyer. if es > ed, the incidence of the tax is in higher proportion upon the buyer than upon the seller. if ed > es, the incidence of the tax is in higher proportion upon the seller than upon the buyer.

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Additional Factors Influencing Tax Shifting

Main Factors Influencing Tax Shifting: Elasticity of supply Elasticity of demand Additional Factors Influencing Tax Shifting: Type of tax transaction tax easier to shift Price being fixed and accepted as normal difficult to shift through price variation Tax rate small tax chosen to be borne by the seller in a competitive situation Tax on commodity having close and effective substitute difficult to shift Geographical coverage of a tax if tax not imposed in neghbouring areas, difficult to shift

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General Effects of Taxation

Effects of Taxation are the changes in the economy resulting from the imposition of a tax system (or a variation in it). Usual working of tax measures in a market economy:
1. 1. All tax measures would work through either influence on the demand and the supply forces in the market. The tax measures either reduce the disposable income of the buyers (individuals, firms and so on) and thereby affect their demand, or they have an important bearing upon the economy through supply efforts of taxation. Elasticity of supply (es) and elasticity of demand (ed) are the major determinants in the detailed results of taxation. On account of the shifting of incidence, both demand and supply reactions may get mixed up leading to further rounds of effects, which is called announcement effects (Pigou).

1.

Taxation policy should be as follows to optimum allocation of resources at the equilibrium point where the social indifference curve is tangent with the production possibility curve.

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General Effects of Taxation

Effect on

Effects of Direct Tax

Effects of Indirect Tax

Income Higher direct taxes reduce disposableUsually the imposition of income by curtailing the incomean indirect tax increases directly. In the countries wherethe price of the concerned unemployment allowances aregoods or services. Thus provided, the situation becomes worsethe purchaser has to pay when an unemployed getsmore, which reduces the employment but falls in the lowernet income. income-bracket, because then he will not receive the unemployment benefit and at the same time he has to pay tax. This is called unemployment trap.

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General Effects of Taxation

Effect on Effects of Direct Tax Effects of Indirect Tax Savings and Higher direct taxes reduce the abilityUsually it is said that higher indirect tax Invest-ment of the tax-paying individuals orindirectly encourages savings, because it enterprises to save or invest. But itincreases price and thereby reduces depends on the extent of financing thedemand. But in the overall effect, higher enhanced tax from savings orindirect taxation decreases savings and consumption. investments. Price Higher direct taxes have a deflationaryIndirect taxation usually increases price effect on price by decreasing thelevel and it has an inflationary effect. But demand. But labour organizations maythe extent of inflationary effect depends create pressure to increase the wageon the price elasticities of demand and level to meet the higher taxes, whichsupply. If the price elasticity of supply is may cause a cost-push inflationarymore than the price elasticity of demand, effect. then the price will rise and if the price elasticity of demand is higher, then the price will fall.

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General Effects of Taxation

Effect on Initiative Effects of Direct Tax Effects of Indirect Tax

Higher direct taxes have a negativeHigher indirect tax has also a effect on initiative, because then thenegative effect on the business leisure will be more preferable tocommunitys initiative, because work. But it is sometimes said, due toit is seen as an impediment to higher direct tax some will do moretheir trade and commerce works in order to maintain thecausing a price barrier. standard of living.

Overall Other things remaining the same, as a result of higher taxation, Economy aggregate demand of the economy will fall, which may cause an

inflationary effect on the price and output levels. Balance of payments may be improved by decreasing the dependency on foreign aid. But the employment situation may be worsen due to the fall in aggregate demand. Besides, taxation may affect regional disparity, inequality between income and wealth, etc.

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End of the Presentation

Thank you.