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Elasticity and tax burdens

In any year, tax reform seems to be one of the top domestic issues facing the United States. The phrase "tax reform" is just empty rhetoric un­less we know who bears the burden of various taxes. Elasticity plays a major role in answering the question of who bears the tax burden.

The legal incidence of a tax falls on the individual or firm responsible for writing the check for taxes to government. The economic incidence of taxation (or tax bur­den) falls on the person who suffers reduced pur­chasing power because of the tax.

Tax burdens can be avoided by the party bear­ing the legal incidence through tax shifting. A tax passed on to the consumer in the form of higher prices is forward shifted. Taxes are backward shifted, if tax burdens are transferred to workers in the form of lower take-home wages or to other re­source suppliers in the form of lower factor pay­ments.

Taxing a good drives a wedge between the price paid by buyers and the net price received by sellers. The government is a third party to the transaction causing the price paid by the buyer to exceed the price received by the seller. The tax burden tends to be shared between buy­ers and sellers.

The intersection of taxed supplies and de­mands helps to identify the proportions of taxes borne by buyers and sellers. Note that the tax reduces incentives to produce as well as incentives to buy. Part of the tax burden is borne by consumers in terms of higher prices, and part is borne by sellers (or their employees or resource suppliers) in terms of lower output, employment, and sales. This may create inefficiency and is one reason economists refer to tax wedges as creating disincen­tive effects.

A critical point is that, after adjusting for taxes, the quantity demanded at the total price paid by the buyer must equal the quantity sup­plied at the net price received by the seller; nei­ther excess demands (shortages) nor excess supplies (surpluses) can exist. Considering ex­treme elasticities helps us develop general prin­ciples about tax burdens.

Taxes will be 100% forward shifted (borne by consumers) if either (a) demand is perfectly in­elastic (e.g., salt) or (b) supply is perfectly elastic (e.g., aluminum). Taxes will be backward shifted completely (borne by suppliers) if either (a) sup­ply is perfectly inelastic (e.g., land) or (b) demand is perfectly elastic (e.g., copper). You may be­lieve that these extreme cases of elasticities are rare in the real world. You will also learn that competitive markets can result in individual buyers confronting perfectly elastic supplies and in individual firms facing perfectly elastic demands for their products.

Few products have market demands and supplies that are either perfectly inelastic or per­fectly elastic, but our examples do suggest a workable general principle: The greater the elasticity of market demand relative to the elas­ticity of market supply, the greater the backward shifting of any tax burden. The smaller the ratio (elasticity of demand)/'(elasticity of supply), the greater the forward shifting of the tax burden.

Elasticity is vital for understanding the de­cisions of consumers and suppliers. 2627 digits