Model Answer
0 min readIntroduction
Tax incidence refers to the actual sharing of the burden of a tax between buyers and sellers. While a tax is legally levied on one party, the economic burden can be distributed differently based on the price elasticity of demand and supply in the market. Understanding this distribution is crucial for evaluating the efficiency and equity of tax policies. The relative elasticities determine which side of the market – consumers or producers – bears a larger share of the tax burden. This concept is fundamental to public finance and impacts policy decisions related to taxation and welfare.
Understanding Price Elasticity
Price elasticity of demand (PED) measures the responsiveness of quantity demanded to a change in price. PED is calculated as (% change in quantity demanded) / (% change in price). Similarly, price elasticity of supply (PES) measures the responsiveness of quantity supplied to a change in price, calculated as (% change in quantity supplied) / (% change in price).
Tax Incidence and Elasticity: The Mechanism
When a tax is imposed, it creates a wedge between the price buyers pay and the price sellers receive. The extent to which each side bears the burden depends on their respective elasticities.
Scenario 1: Elastic Demand, Inelastic Supply
If demand is relatively elastic (consumers are very responsive to price changes) and supply is relatively inelastic (producers are not very responsive to price changes), buyers will bear a larger share of the tax burden. This is because producers cannot easily reduce output in response to the tax, so they pass on most of the tax to consumers in the form of higher prices. The quantity traded will fall only slightly.
Scenario 2: Inelastic Demand, Elastic Supply
Conversely, if demand is relatively inelastic (consumers are not very responsive to price changes) and supply is relatively elastic (producers are very responsive to price changes), sellers will bear a larger share of the tax burden. In this case, producers can easily adjust output, and consumers are less sensitive to price increases, so producers absorb more of the tax by accepting lower prices.
Scenario 3: Equal Elasticity
If the price elasticity of demand and supply are equal, the tax burden is shared equally between buyers and sellers. The price increases by the full amount of the tax, and the quantity traded falls proportionally.
Mathematical Representation
The proportion of the tax burden borne by buyers and sellers can be approximated as follows:
- Buyer’s share of tax burden: PES / (PES + PED)
- Seller’s share of tax burden: PED / (PES + PED)
Where PES is the price elasticity of supply and PED is the price elasticity of demand.
Examples
Example 1: Cigarettes (Inelastic Demand) – Demand for cigarettes is relatively inelastic. Therefore, when a tax is imposed on cigarettes, consumers bear a larger share of the burden through higher prices.
Example 2: Agricultural Products (Elastic Supply) – Supply of many agricultural products is relatively elastic. If a tax is imposed on agricultural products, producers bear a larger share of the burden, potentially leading to lower incomes for farmers.
| Elasticity Scenario | Buyer’s Burden | Seller’s Burden | Quantity Change |
|---|---|---|---|
| Elastic Demand, Inelastic Supply | High | Low | Small Decrease |
| Inelastic Demand, Elastic Supply | Low | High | Large Decrease |
| Equal Elasticity | Equal | Equal | Moderate Decrease |
Conclusion
In conclusion, the distribution of the tax burden between buyers and sellers is fundamentally determined by the relative price elasticities of demand and supply. A more elastic side of the market will bear a smaller share of the burden, as they are more sensitive to price changes. Understanding this principle is vital for policymakers aiming to design efficient and equitable tax systems, considering the potential impact on both consumers and producers. The concept highlights that the legal incidence of a tax (who writes the check) is distinct from its economic incidence (who truly pays).
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.