Tax Incidence

The person who hands the tax to the government is not always the one who ends up paying for it. If a tax is placed on sellers, they may raise their prices and pass some of it on to buyers. If it is placed on buyers, sellers may have to lower their prices to keep customers.

How the burden is shared depends on the price elasticities of supply and demand. The side that is less able to change its behaviour bears more of the tax. If buyers have no good alternatives and keep buying even as prices rise, as with petrol or cigarettes in the short term, most of the tax falls on them. If buyers can easily switch, sellers must absorb more of it.

For example, suppose a tax of 1 is placed on each pack of a product. If the price paid by buyers rises by 0.80 and the price received by sellers falls by 0.20, buyers bear 80% of the tax and sellers 20%.

Understanding tax incidence helps governments predict who will really be affected by a tax and whether it will achieve its goals.