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Tax incidence

Tax incidence

The law establishes from whom a tax is collected. In many countries, taxes are
imposed on businesses (such as corporate taxes or portions of payroll taxes).
However, who ultimately pays the tax (the tax “burden”) is determined by the
marketplace as taxes become embedded into production costs. Depending on
how quantities supplied and demanded to vary with price (the “elasticity” of
supply and demand), a tax can be absorbed by the seller (in the form of lower
pre-tax prices), or by the buyer (in the form of higher post-tax prices). If the
elasticity of supply is low, more of the tax will be paid by the supplier. If the
elasticity of demand is low, more will be paid by the customer. And
contrariwise for the cases where those elasticities are high. If the seller is a
competitive firm, the tax burden flows back to the factors of production
depending on the elasticity thereof; this includes workers (in the form of
lower wages), capital investors (in the form of loss to shareholders),
landowners (in the form of lower rents) and entrepreneurs (in the form of lower
wages of superintendence).

To illustrate this relationship, suppose the market price of a product is $1.00,
and that a $0.50 tax is imposed on the product that, by law, is to be collected
from the seller. If the product has an elastic demand, a greater portion of the tax
will be absorbed by the seller. This is because goods with elastic demand cause
a large decline in quantity demanded for a small increase in price. Therefore, in
order to stabilize sales, the seller absorbs more of the additional tax burden. For
example, the seller might drop the price of the product to $0.70 so that, after
adding in the tax, the buyer pays a total of $1.20, or $0.20 more than he did
before the $0.50 tax was imposed. In this example, the buyer has paid $0.20 of
the $0.50 tax (in the form of a post-tax price) and the seller has paid the
remaining $0.30 (in the form of a lower pre-tax price).

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