Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Tax Incidence

What it is:

Tax incidence is a term that describes whether producers or consumers bear the burden of a new tax.

How it works (Example):

For example, let's assume that Congress passes a bill that places a $0.10 per ounce tax on potato chips in an effort to curb obesity in the United States. A 20-ounce bag of potato chips would be taxed $2 under the new law, if signed by the President. The law would also require the manufacturers to remit the tax on every bag of chips sold.

Who really pays the tax? The chip manufacturer could simply write a check to the IRS and take the hit, possibly creating a situation whereby chips are no longer profitable to sell or are less profitable to sell. As a consequence, the company may need to lay employees off in order to stay alive.

Alternatively, the chip manufacturers could make consumers pay the tax by increasing the price of a 20-ounce bag of chips by $2. But that might increase the price of a bag of chips from, say, $4 to $6, a price at which consumers might stop buying as many chips. Consequently, this tactic would also reduce or eliminate profits and force the company to lay off employees in order to stay alive.

Assume that the company does the latter (raises prices). If it turns out that the company still sells just as many bags of chips as it did before the tax-related price increase, then we know the tax incidence "falls" upon the consumers. That is, the consumers are willing to shoulder the burden of the tax. If, however, demand for chips drops off as expected, then the tax incidence falls -- at least in part -- on the producer.

Why it Matters:

Tax incidence is a way to measure the true impact of taxes. At least one state study finds that when a new tax is created, over 80% of the burden ultimately falls on residents. This is important to understand because there is often a separation between who is statutorily assigned to pay a tax and who actually bears the burden of the tax. (In our example, the chip manufacturer has to write the check to the IRS, but, similar to sales taxes, the consumer is the one actually forking over the money for the tax.) Tax incidence identifies this discrepancy.