Incidence of taxation refers to the point at which the tax burden finally rests. The burden here refers to the amount paid as tax. The incidence or burden of taxation therefore lies on the person who finally pays the tax.
Types of incidence of taxation
- Formal incidence: This refers to the initial effects of tax on the tax object i.e. the tax payer. It shows where the initial burden of taxation lies. For direct tax, the initial burden of tax is borne by the payer. The producers or manufacturers bear the initial burden of tax in the case of indirect taxes.
- Effective incidence: The effective incidence of tax makes reference to who bears the final burden of taxation. With reference to direct taxes, the payer bears the full (initial and final) burden of taxation. For instance, a person who pays income tax bears the full burden of tax and he cannot shift it to another person. In the case of indirect taxes, the burden of taxation may be borne by the producer (seller) or the consumer or shared between them. The extent to which either or both of them bear the burden of taxation will depend on the elasticity of demand for the commodity which is taxed.
a) Incidence of indirect tax when demand is perfectly inelastic: The burden of an indirect tax on a commodity whose demand is perfectly inelastic is borne by the consumer. In this case, the whole tax burden can easily be shifted to the consumer by the producer (or seller) in the form of higher prices because increase in price does not bring about any change in quantity demand.
In fig. 21.1 The tax is represented by AB. This tax increases the manufacturer’s cost of production. Since the same quantity is purchased irrespective of the price, the manufacturer increases the price of the product from P1 to P2. The consumer bears the full burden represented by rectangle P1BAP2.
b) Incidence of indirect tax when demand is perfectly elastic: If demand for a commodity is perfectly elastic, the producer or seller will bear the whole burden of taxation. This is so because any attempt to increase price will make the demand for the product fall to zero. The tax burden under this situation cannot be passed to the consumer.
In fig. 21.2, the tax is represented by EF. Since the tax increases the manufacturer’s (seller) cost of production, the quantity supplied decreased from Q1 to Q2. However, the price remains at P since any attempt to increase price will make demand to drop to zero. The manufacturer or seller therefore bears the whole tax burden represented by rectangle PEFG.
c) Incidence of indirect tax when demand is moderately elastic or moderately inelastic: If the demand is moderately elastic or moderately inelastic, the burden of taxation will be shared between the producer (or the seller) and the consumer.
The more inelastic the demand for the commodity, the more the burden of tax is shifted to the consumer. On the other hand, the more elastic the demand for the commodity, the greater the burden of taxation the producer (or seller) bears.
In fig. 21.3 the producer or seller bears the tax burden represented by P1HIJ while the buyer bears P2GHP1. The producer therefore bears the greater burden.
But in fig. 21.4, the area which represents the burden borne by the consumer is larger than that of the producer or seller.
d) Incidence of tax when demand is unitary: If demand is unitary, the tax burden is shared equally between the producer (or seller) and the consumer.
In fig. 21.5, the producer passed half of the tax burden to the consumer in the form of higher prices. The tax is represented by RT, and the price increases from P1 to P2. The tax burden borne by the consumer is represented by P1SRP2 while the tax burden borne by the seller or producer is represented by VTSP1. The two rectangles are equal because both the consumer and the producer bear incidence of taxation equally.