Who Bears the Burden of Tax?

Tax incident is the study of who bears the burden of taxes. Because taxes decrease quantity demanded and consequently quantity supplied, the market size also decreases. Thus taxes discourage market activity.

Government is also a participant in the process of taxation. Tax revenue for government is spent on many public services. Since the amount of tax is the difference between price received by sellers and price paid by buyers, the tax revenue for government is amount of tax per quantity times quantity sold, which is the rectangular area between supply and demand curve.

Without a tax, the equilibrium price will be at Pe and the equilibrium quantity will be at Qe. After a tax is imposed, the price consumers pay will shift to Pc and the price producers receive will shift to Pp. The consumers' price will be equal to the producers' price plus the cost of the tax. Since consumers will buy less at the higher consumer price (Pc) and producers will sell less at a lower producer price (Pp), the quantity sold will fall from Qe to Qt.

In the new equilibrium, the quantity demanded and quantity supplied are both smaller than those of the old equilibrium. Buyers pay more, sellers receive less. Buyers and sellers share the burden of taxation.

So who is bearing the burden of tax? It does not matter whether the taxes are levied on the buyers or sellers. The buyers and sellers will eventually share the taxes when the market reaches a new equilibrium.

When a $0.30 tax is levied on sellers, the supply curve is shifted to the left (a tax on good for sellers is equivalent to higher production costs) and demand curve does not change. At the new equilibrium, the new equilibrum price is $1.15 so buyers (originally pay $1.00) have to pay $0.15 more and sellers only receive $0.85 ($0.15 less) because of the tax.

When a $0.30 tax is levied on buyers, the demand curve is shifted to the left (a tax on good for buyers is equivalent to higher prices) and supply curve does not change. At the new equilibrium, the new equilibrum price is $0.85 so buyers (originally pay $1.00) have to pay $1.15 ($0.15 more) due to taxes and sellers only receive $0.85 ($0.15 less than without taxes).

The burden of tax falls more heavily on the one with more inelastic quantity. This is because the side that is more willing to leave the market when a tax is imposed will bear lower tax burden.