When the price elasticity of demand is low and the price elasticity of supply is high who does the tax burden fall on?

What Is a Tax Incidence?

"Tax incidence" (or incidence of tax) is an economic term for understanding the division of a tax burden between stakeholders, such as buyers and sellers or producers and consumers. Tax incidence can also be related to the price elasticity of supply and demand. When supply is more elastic than demand, the tax burden falls on the buyers. If demand is more elastic than supply, producers will bear the cost of the tax.

Key Takeaways

• A tax incidence describes a case when buyers and sellers divide a tax burden.
• A tax incidence will also lay out who bears the burden of a new tax, for instance among producers and consumers, or among various class segments of a population.
• The elasticity of demand of a good can help understand the tax incidence among parties.

How a Tax Incidence Works

The tax incidence depicts the distribution of the tax obligations, which must be covered by the buyer and seller. The level at which each party participates in covering the obligation shifts based on the associated price elasticity of the product or service in question as well as how the product or service is currently affected by the principles of supply and demand.

Tax incidence reveals which group—consumers or producers—will pay the price of a new tax. For example, the demand for prescription drugs is relatively inelastic. Despite changes in cost, its market will remain relatively constant.

Levying New Taxes on Inelastic and Elastic Goods

Another example is that the demand for cigarettes is mostly inelastic. When governments impose a cigarette tax, producers increase the sale price by the full amount of the tax, transferring the tax burden to consumers. Through analysis, it is found the demand for cigarettes is unaffected by price. Of course, there are limits to this theory. If a pack of cigarettes suddenly increased from $5 to $1,000, consumer demand would fall.

If the levying of new taxes on an elastic good, such as fine jewelry, occurs, most of the burden would likely shift to the producer as an increase in price may have a significant impact on the demand for the associated goods. Elastic goods are goods with close substitutes or that are nonessential.

Price Elasticity and Tax Incidence

Price elasticity is a representation of how buyer activity changes in response to movements in the price of a good or service. In situations where the buyer is likely to continue purchasing a good or service regardless of a price change, the demand is said to be inelastic. When the price of the good or service profoundly impacts the level of demand, the demand is considered highly elastic.

Examples of inelastic goods or services can include gasoline and prescription medicines. The level of consumption across the economy remains steady with price changes. Elastic products are those whose demand is significantly affected by price. This group of products includes luxury goods, houses, and clothing.

The formula for determining the consumer's tax burden with "E" representing elasticity is as follows:

• E (supply) / (E (demand)) + E (supply)

The formula for determining the producer or supplier's tax burden with "E" representing elasticity is as follows:

• E (demand) / (E (demand) + E (supply))

What Does Tax Incidence Determine?

Tax incidence shows who or what ultimately bears the burden of a tax, as opposed to just who directly pays the tax.

Are Consumers or Retailers Impacted More By Tax Incidence?

A number of different parties can be impacted by tax incidence, such as when a consumer has to pay higher sales taxes, and therefore spends less at a retailer, ultimately hurting the retailer's sales and leading to job cuts or store closings.

What Is Elastic Vs. Inelastic Demand?

Elastic demand is demand that rises or falls based on the price of the service or product, state of the economy, or financial health of the person. Inelastic demand is demand that is, to an extent, impervious to price fluctuations, the state of the economy, tax incidence or any other financial consideration. It is the difference between something like entertainment or self-care purchases versus food and medicine.

Here is a short video looking at how to build a chain of reasoning for this question. "Explain how the incidence of a tax depends on the price elasticity of demand and the price elasticity of supply."

Suggested answer

The incidence of a tax refers to who eventually pays a tax. An indirect tax on producers increases their costs and this will lead to an inward shift of the supply curve. Once the tax is imposed, suppliers may then chose to pass on the tax to consumers by raising their selling price. This depends on the coefficient of price elasticity of demand.

When demand is inelastic (i.e. Ped<1), then most of the tax can be passed on. This is because consumers are less sensitive to price changes, e.g. a 20% increase in price might only lead to a 5% contraction in demand. However, when demand is price elastic (i.e. Ped>1), then most of the incidence of a tax is absorbed by the producer. In this situation, only a small proportion of the tax will be paid by the consumer. 

The incidence of an indirect tax also depends on the coefficient of price elasticity of supply.

When supply is perfectly elastic (i.e. Pes= infinity) this means that output can be supplied at constant cost. A tax on producers again causes an inward shift of the supply curve. But in this situation, all of the tax will be paid by the consumer, regardless of the coefficient of PED. When demand is elastic, the consumer pays all of the tax, but equilibrium quantity will contract by a large amount.

When the price elasticity of demand is low and the price elasticity of supply is high the burden of a tax falls mainly on producers?

When the supply is more elastic the burden of taxes?

Who bears the tax burden when supply is perfectly elastic?

When supply inelastic and demand is elastic What is the tax incidence falls on?