Elasticity and Tax Incidence

When a good is taxed buyers and sellers of the good share the burden of the tax. But how exactly is the tax burden divided? Only rarely will it be shared equally. To see how the burden is divided consider the impact of taxation in the two markets. In both cases figure shows the initial demand curve the initial supply curve and a tax that drives a wedge between the amount paid by buyers and the amount received by sellers. Not drawn in either panel of the figure is the new supply or demand curve. Which curve shifts depends on on whether the tax is levied on buyers or sellers. As we have seen this is irrelevant for the incidence of the tax. The difference in the two panels is the relative elasticity of supply and demand.

A tax in a market with very elastic supply and relatively inelastic demand. That is sellers are very responsive to changes in the price of the good so the supply curve is relatively flat whereas buyers are not very responsive so the demand curve is relatively steep. When a tax is imposed on a market with these elasticities the price received by sellers does not fall much so sellers bear only a small burden. By contrast the price paid by buyers rises substantially indicating that buyers bear most of the burden of the tax.

A tax in a market with relatively inelastic supply and very elastic demand. In this case sellers are not very responsive to change the in the price so the supply curve is steeper whereas buyers are very responsive so the demand curve is flatter. The shows that when a tax is imposed the price paid by buyers does not rise much buy the price received by sellers falls substantially. Thus sellers bear most of the burden of the tax.

A general lesson about how the burden of a tax is divided. A tax burden falls more heavily on the side of the market that is less elastic. Why is this true? In essence the elasticity measures the willingness of buyers or sellers to leave the market when conditions become unfavorable. A small elasticity of demand means that buyers do not have good alternatives to consuming this particular good. A small elasticity of supply means that sellers do not have good alternatives to producing this particular good. When the good is taxed the side of the market with fewer good alternatives cannot easily leave the market and must therefore bear more of the burden of the tax.

We can apply this logic to the payroll tax discussed in the previous case study. Most labor economists believe that the supply of labor is much less elastic than the demand. This means that workers rather than firms bear most of the burden of the payroll tax. In other words the distribution of the tax burden is not at all close to the fifty-fifty split that lawmakers intended.

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