Modern Theory of Tax Incidence

What is Tax Incidence?

Tax Incidence or Incidence of Tax refers to the money burden of the tax. Simply put, tax incidence relates to the final resting place of the tax. When a tax is levied, its money burden falls on one individual or another. Under tax incidence, one tries to find out where the burden of money falls or who bears the money burden of the tax. 

Impact of Tax Incidence and Incidence of Tax Incidence are two different concepts. The impact of tax falls on the person who pays the tax, first. However, the incidence of tax falls on the person who ultimately pays the tax. It is because the person who pays the tax in the first instance does not necessarily bears the monetary burden of the tax. In simple terms, the impact is the original burden of the tax; however, the incidence is the ultimate burden of the tax. 

For example, when the government levies export duty on rice, which is first paid by the rice mill owner. Therefore, the impact of export duty on rice is on the mill owner. But, it does not mean that the incidence of export duty will also fall on the mill owner. The mill owner will now pass on the export duty burden to the consumer by charging higher prices. It means that the owner will add the amount of export duty to the price of rice and then charge it from the consumer. Thus the incidence of export duty on rice will be borne by the consumer. 

Modern Theory of Tax Incidence:

The Modern Theory of Tax Incidence primarily deals with the incidence of commodity taxation. This theory states that one can pay tax out of surplus only. It means that if a taxpayer is enjoying a surplus, he will pay the tax out of that surplus. However, if the taxpayer does not enjoy a surplus, he will shift the tax burden on the shoulders of someone else. Besides, the tax imposed on a commodity is an essential element in its production cost. Therefore, the commodity’s price must cover it up. Simply put, the price of a commodity consists of the tax levied on it. 

One thing that should be kept in mind is that the tax incidence on a commodity cannot be shifted without making some transaction with another party/ consumer. It means that without making a transaction tax incidence cannot be shifted in a forward or a backward direction. Therefore, tax shifting depends upon the process of pricing. As we know that pricing is the function of the forces of demand and supply, based on this fact, the modern theory of incidence is considered as part and parcel of the theory of pricing. 

The process of shifting in commodity taxation is quite common and widely spread. The tax burden either falls on the buyer or the seller. If the price of the commodity increases by the amount equal to the tax, then the tax incidence or money burden is put wholly on the buyer. If the price of the commodity does not increase at all, then the tax incidence or money burden is put entirely on the seller. However, if the price of the commodity increases by an amount less than the tax, then the tax incidence or money burden is put partly on the buyer and partly on the seller.

According to modern theory, the factors influencing the incidence of commodities taxation are as follows:

1. Elasticity of Demand and Supply of Commodities

The elasticity of the supply and demand of the commodity significantly determines its tax incidence. The trader will be responsible for paying the tax if the commodity’s demand is elastic. It is so because if the trader tries to pass the tax burden by increasing the price of the commodity, consumers would either stop buying it or consume it to the minimum. The trader will thus suffer significant financial losses. Hence, the trader would consequently choose to pay the tax himself. 

If there is an inelastic demand for the good, the traders can easily pass on the tax burden on the shoulders of the consumers. In this case, the trader can immediately raise the price of the commodity by the amount of the tax, and since there is an inelastic demand for the good, customers will be forced to pay the higher price. Therefore, as the trader has strong bargaining power than the consumer, the incidence of tax on necessities of life can be entirely transferred onto the consumer. In contrast, as there is little scope to raise the price of the luxuries, the trader usually pays the taxes imposed on the luxury goods.

The burden of paying tax; i.e., tax incidence will fall on the trader if the commodity’s supply is inelastic (or if it is easily perishable) because the trader cannot store it for an extended period of time due to its perishability. In this case, as compared to the customers, the position of the trader is weaker. Therefore, the trader will bear the entire tax burden. However, if the supply of the commodity is elastic (if the commodity is not perishable), then in such a situation, the tax burden will fall on the consumers because the trader’s bargaining power is greater than that of the consumers because the commodity is non-perishable. As such, the trader can easily pass on the tax burden to the consumers.

According to Dr Dalton, every trader tries to put the burden of the tax on the consumers by reducing the supply of the commodity. Similarly, every customer seeks to shift the cost of the tax to the trader by decreasing his demands to the barest minimum. Consequently, the incidence of the tax has been distributed between the trader and the consumer based on their respective bargaining power.

In the case of the modern theory of tax incidence, the following two major propositions can be made:

1. Other things being equal, the higher the elasticity of demand, the higher the tax incidence on the seller.
2. Other things being equal, the higher the elasticity of supply, the higher the tax incidence on the buyer.

The following conclusions can be derived after considering the various elasticities in demand and supply situations:

1. The buyer will bear the full burden when the demand is perfectly inelastic and the supply is elastic.
2. The seller will bear the full burden when the demand is perfectly elastic and the supply is inelastic.
3. The seller will bear the full burden when the supply is perfectly inelastic and the demand is elastic.
4. The buyer will bear the full burden when the supply is perfectly elastic and the demand is inelastic.

Generally, the ratio of elasticity of supply to the elasticity of demand will determine how the tax incidence is divided between the buyer and the seller.

2. Presence of Substitutes

Certain commodities have perfect or close-to-perfect substitutes available in the market. For instance, Pepsi and Coke are appropriate substitutes. The Pepsi trader cannot pass on the burden to the customers if the government imposes a high excise tax on Pepsi. It is because if he shifts the tax burden to consumers in the form of increased prices, consumers might start buying Coke instead of Pepsi, as it is a great substitute.

3. Effect of Laws of Production

It is necessary to consider the laws that apply to the production of the commodity when the incidence of a tax on that commodity is examined. There are three laws to govern the laws of production: (i) Law of Increasing Returns; (ii) Law of Diminishing Returns; and (iii) Law of Constant Returns.

(i) Law of Increasing Returns:

Let’s assume that the government imposes a tax on a good being produced according to the Law on Increasing Returns. In this case, the price of the will rise by more than the amount of the tax.

For example, A company is producing 500 units of the commodity at a cost of production (including normal profits) of ₹3 per unit. Now, imagine that the government imposes an excise tax of 25 paise per unit. The commodity’s price per unit would now increase to ₹3.25 because of which the demand for the commodity will decrease. To keep up with a decreased demand, the company will have to decrease the level of production. As the product is being manufactured under the law of increasing returns, the price per unit of the commodity will ultimately rise after reducing production. After making the assumption that the per unit cost of production of the given commodity rises up to ₹3.12, and as there is a tax levied on it too, the price of the commodity will rise to ₹3.37 per unit. Now, it can be seen that the commodity’s price has increased by a greater ratio than the tax increase; i.e., the tax is only 25 paise per unit, but the price of the commodity has increased by 37 paise per unit.

Note: It should be kept in mind that subject to the law of increasing returns if the production of a commodity is decreased, its production cost will increase. On the other hand, if the production of the commodity is increased, the cost of production per unit of demand decreases.

(ii) Law of Decreasing Returns:

Let’s assume that the government imposes a tax on a good being produced according to the Law on Decreasing Returns.

For example, In the above case, imagine that the government imposes an excise tax of 25 paise per unit. The commodity’s price per unit would now increase to ₹3.25. Now, the demand for the commodity will decrease as a result of the price increase. To keep up with a decreased demand, the company will have to cut down the level of production. As the commodity, in this case, is being produced under the Law of Decreasing Returns, after reducing the production level, the cost of production per unit will fall automatically. After making the assumption that the per unit cost of production of the given commodity falls down to ₹2.95 and the tax on the commodity is 25 paise per unit, the price of the commodity will rise to ₹3.10 per unit only. In other words, the price of the commodity rises to a lesser extent than warranted by tax imposition.

(iii) Law of Constant Returns:

The application of this law has no impact on the cost of production of the commodity. Whether production is increased or decreased, the cost of manufacturing per unit remains the same. Hence, the commodity’s price will increase in line with the magnitude of the tax.

For example, In the above case, if the tax is 25 paise per unit, the commodity’s price will only increase to ₹3.25.

In general, commodities that are produced under the law of decreasing returns are considered to be useful commodities for taxation. However, commodities that are produced under the law of increasing returns are suitable for obtaining government subsidies.

4. Tax Amount and the Taxation System

If the tax burden placed on the commodity is small, the trader may prefer not to pass it along to the consumers because he would prefer not to upset them. However, if the tax rate is high, a trader will try to shift the burden to the consumers.

5. Mobility of Capital

If the capital is perfectly mobile, then the producer can easily pass on the tax burden to the consumers. Simply put, in such a case, the capital invested by the manufacturer in his business can be easily withdrawn. However, if the manufacturer has invested a lot of capital in the business (in fixed assets) and cannot easily withdraw it, then the producer can not pass on the tax burden to the consumers; i.e., the producer will have to himself bear the tax burden.