Tax incidence is the degree to which a given tax is paid or borne by a particular economic unit such as consumers, producers, employers, employees etc. When we say that the tax incidence of a given tax falls on A, it means A ultimately pays or bears the burden of tax in greater proportion. Tax incidence is of two types: statutory incidence and economic incidence.
Statutory incidence or nominal incidence of a given tax is the degree to which the tax is actually paid by an economic unit in the form of cash, check etc. (Tax may be collected and deposited in government's treasury by someone else). Statutory incidence is stated in tax law. For example, at the time or writing, US tax laws require that tax on salary income of an employee must be borne 50% by employer and 50% by employee. In this case, statutory incidence of tax equally falls on employer and employee.
Economic incidence of a given tax is the degree to which the burden of the tax is borne by an economic unit in the form of reduced resources. Economic incidence of a tax does not necessarily fall on the same economic unit on which its statutory incidence falls. Rather it depends on the elasticity of demand and supply. When demand is inelastic and supply elastic, tax burden is mainly on the consumer; in case of inelastic supply and elastic demand, tax incidence falls mainly on producer. When both demand and supply are moderately elastic the tax incidence is distributed between producers and consumers.
Economic tax incidence is explained in the following example:
Suppose a tax of $1 per unit is imposed on sale of product X. If the demand of the product is perfectly inelastic and supply elastic, the suppliers will be able to shift all of the economic incidence of the tax to consumers by restricting supply causing increase in price of product X by $1. Producers will be able to earn same amount of revenue as before the imposition of tax. Only consumers will suffer in this case.
If the above $1 tax per unit is imposed under perfectly inelastic supply, producers will have the bear all the burden of the tax since they will not be able to control the price of the product when supply is perfectly inelastic.
When both demand and supply are moderately elastic, the product's price will increase slightly as a result of $1 tax per unit but the increase will be lower than $1. Consumers will bear some burden of the tax by paying slightly higher price. Producers will also face moderate tax incidence because the increase in price is less than the tax per unit.
Written by Irfanullah Jan