Concept of Tax
A tax is a compulsory contribution of the wealth of a person or body of persons for the service of the public powers. It is ‘compulsory’ as the will of the payer is legally immaterial, ‘contribution’ as a sacrifice is involved on the part of the payer, ‘wealth’ includes commodities as well as services, all taxation is imposed on ‘persons’, taxation is levied for ‘service’ or ‘benefit’, and taxation is for the ‘public powers’, i.e. it has to meet the wants of both central and local governments (Bastable, 1892).
In India, the Constitution authorizes central and state governments with the right to levy taxes. Besides, local authorities also levy some minor taxes. Generally, taxes are levied in monetary terms, and its nature can be direct or indirect. The government is expected to use the tax money to provide various welfare and public services.
Various types of taxes are levied, and their rates are varied over time in order to induce desired changes in consumption patterns or to influence the macroeconomic performance of the economy and also to distribute the burden of tax among persons in an equitable or efficient way.
Average Tax Rate and Marginal Tax Rate:
- Average Tax Rate: It refers to the ratio of tax liability to income. The average tax rate is said to be progressive, regressive or proportional if it increases, decreases or remains constant with income, respectively. The greater the increase in average tax rates with the increase in income, the more progressive it is.
- Marginal Tax Rate: It refers to the change in taxes with respect to a change in income. The higher the elasticity of tax revenues with respect to income, the more progressive the tax system is.
Meaning of Tax Incidence
Tax incidence is the final placing of a tax. The incidence of a tax is the monetary burden on the person who ultimately bears it, i.e. who cannot shift the burden to any other person. Generally, who ultimately pays the tax or bears its burden (the economic incidence) is independent of who is legally or statutorily required to pay the tax (the nominal incidence).
The monetary burden of a tax is different from the real burden. While money burden refers to the total amount of money the government receives, real burden indicates the loss of economic welfare owing to a tax.
Further, the incidence of a tax is different from its impact and effects. The impact of a tax is on the person who has the first responsibility to pay it, whereas the incidence is on the final consumers. Further, the effect of a tax refers to the consequences of tax imposition. For example, if demand decreases due to a tax increase, then a decrease in demand is the effect of tax imposition.
Theories of Tax Incidence:
The theory of incidence plays a critical role in shaping tax policy as the burden of a tax does not necessarily fall on the person who pays it in the first instance; it often gets shifted to other people. Therefore, it can have unintended consequences. For example, business taxes can be shifted backwards as lower wages or shifted forward as higher prices to consumers. Therefore, for an effective tax policy, it is crucial to know who bears the ultimate burden of a tax.
Basically, the theories can be divided into two groups: Earlier Theories (The Concentration and Diffusion Theory) and The Modern Theory.
Concentration Theory of Tax Incidence:
The Concentration theory states that each tax concentrates on a particular object and the burden of tax lies upon a particular section of the society enjoying surplus from their products. In particular, it explains that taxes are paid out of surplus and that agriculture alone is productive, so all taxes should be imposed on the net income of land. If taxes are imposed where there is no surplus, there will be a struggle to shift the burden of taxation through higher prices, which would result in waste in production and damage to consumption.
Diffusion Theory of Tax Incidence:
This theory emphasizes that taxes do not rest at the point of assessment (the assessee). Proponents of this theory were of the view that all taxes tend to diffuse equitably in the entire society through shifting and process of exchange, and the burden of taxation tends to be distributed equally in the society. It assumes that there is no question of just or unjust in the context of a tax as all taxes are distributed all over the society such that nobody either bears the entire burden or escapes from its burden totally. The tax is paid by one but borne by all.
Modern Theory of Tax Incidence:
Modern theory considers the role of market forces in analyzing tax incidence. The tax imposed on factors of production will raise the cost of production, influencing the prices of final products produced with those inputs. Generally, producers/suppliers want to transfer all the burden of new taxes on the buyers by raising the prices of products. It may not always be possible for the producers to do so. The elasticity of the supply and demand curve of the product conditions the extent to which taxes will transfer from producers to consumers. We have analyzed various cases of tax incidence wherein the elasticity of demand and supply changes.
In all the diagrams given below, DD is the original demand curve of the commodity, and SS is the supply curve. OP is the equilibrium price. At this price, consumers purchased an OQ quantity of the commodity.
Suppose the government imposes a tax which increases the commodity’s price to OP1 and decreases the quantity demanded and supplied to OQ1. Per unit, the tax burden is equal to ac, i.e. P2P1. But how the tax burden is distributed between buyers and sellers depends on the elasticity of both demand and supply. In all the diagrams, ac measures per unit total tax collected by the government. Out of ac, ab measures the producer’s tax incidence, and bc measures the buyer’s tax incidence. Various cases are discussed below.
In Figure 1, buyers and sellers share an equal burden of tax because the elasticity of demand and supply are more or less the same. After the imposition of tax, the buyer pays OP1 (or Q1c) prices. Out of Q1c, the sellers get only Q1a, and the rest ac is collected by the government in the form of taxes. ac is per unit tax which is divided equally between buyers and sellers (Figure 1). The buyer’s tax incidence is bc per unit, whereas the producer’s tax incidence is ab per unit.
Figure 2 presents the case wherein the demand curve is less elastic as compared to the supply curve. In such cases, suppliers can easily transfer a larger tax burden on buyers. Due to the relatively inelastic demand curve, the consumer is not in a position to adjust demand in large, whereas the elastic supply curve allows producers to adjust supply according to changing market conditions. Hence, the producer tries to transfer the maximum tax burden on buyers through an increase in prices. Incidence on buyers (bc) is greater than on suppliers (ab) (Figure 2).
Figure 3 demonstrates the case of the demand curve being more elastic than the supply curve. The greater elasticity of the demand curve does not allow suppliers to shift a major proportion of tax onto consumers. Subsequently, producers are forced to bear a larger tax burden (ab>bc). It happens because any change in prices will lead to a substantial reduction in demand for products, which ultimately reduces the revenue of suppliers.
Figure 4 presents the case wherein the supply curve is relatively inelastic. It does not provide much scope for the producers to shift tax to consumers. This is so because the producer is not in a position to reduce the supply of products in larger volume in response to the imposition of the tax, whereas the buyer can reduce the quantity demanded in view of the rise in prices of products. If this is the case, then the supplier has to bear a larger burden of tax (ab>bc).
As observed from Figure 4, the imposition of tax raised prices from OP to OP1 and reduced the quantity demanded from OQ to OQ1. Total revenue after tax is OP1E1Q1. Out of total revenue, the producer’s revenue is OP2aQ1, and the rest is collected by the government in the form of tax. The tax burden is shared between the consumer and producer, but the producer’s tax burden is larger than the consumer’s. For instance, the per unit tax burden on the producer is P2P or ab and on the consumer is PP1 or bc. This happens due to the inelastic nature of the supply curve (Figure 4).
Figure 5 presents the case wherein the supply curve is more elastic as compared to the demand curve. In this case, bc>ab indicates a higher incidence of tax on consumers.
Analysis based on the modern theory of tax incidence suggests that the distribution of tax burden is shared between supplier and buyer. It is the elasticity of demand and supply curve which determines the extent of tax burden between the two agents. An inelastic supply curve allows producers to shift a major portion of the tax on buyers and vice versa.
Alternative Concepts of Tax Incidence:
Besides earlier theories on tax incidence (the concentration theory, the diffusion theory), there are Prof. Musgrave’s views regarding tax incidence, which are often referred to as alternative concepts of tax incidence. While earlier theories do not consider the role of public expenditure, Prof. Musgrave has duly emphasized the role of both public revenue and public expenditure.
According to Prof. Musgrave, incidence refers to the change in the income distribution available for private use, which arises as a result of changes in budget policy. A change in budget policy includes a change in taxation, only a change in public expenditure alone or a simultaneous change in tax and public expenditure.
In other words, whenever there is a change in tax policy or public expenditure (for example, imposition of a tax or incurring public expenditure), there is a resultant change in the distribution of income available for private use, and this change in distribution is referred to as incidence of taxation.
In general, a change in budget policy may result in three effects:
- A change in the transfer of resources from private to public use
- A change in output
- A change in the distribution of income among various sections of the society
It is mainly the third effect, which has been referred to as incidence by Musgrave.
Three Aspects of Taxation: An Example
The imposition of tax leads to a series of wide-ranging changes in the economy. For example, a tax is imposed on a seller producing a product with many substitutes, and the seller tries to shift the burden of the tax on buyers by raising the price. Since many substitutes are available, buyers may not bear the burden by shifting away from the market of taxed products to the market of other substitutes.
The effect of taxation will further trickle down to the employment market as factors will shift from one market to another depending upon the changes in productive activity due to changes in demand for the products of two markets. This is only an indicative example, but the point here is that the effect of taxation is wide-ranging.
Depending upon these effects of taxation on the economy, the total change or total economic consequence can be said to have three aspects:
- Resource transfer impact: involves the transfer of resources from private to public use as a result of taxation.
- The incidence of taxation, also known as the distributional aspect, includes a resulting change in the distribution of income available for private use as a result of a tax.
- Output effect: indicates a change in the level of output or real income as a result of a change in tax.
Distributional Aspect of Taxation:
Further, the distributional aspect or incidence of taxation aspect can be of three types, which are as follows:
1. Absolute Tax Incidence: It examines the effect of a tax on the state of income distribution when there is no change in either other taxes or public expenditure. Absolute incidence analysis does not consider the use of tax revenue and considers only the burden of a change in taxes.
2. Differential Tax Incidence: It examines the difference in incidence when one tax is replaced with another, holding the government budget constant. In other words, a differential incidence analysis considers the change in distribution as one tax is replaced with another.
3. Budget Incidence: It takes into account the combined effects of change in tax and government spending financed by those taxes. The reason for taking government spending into account is that the distributional effect of a tax depends on how the government spends the money collected as tax revenues, which are usually not assigned for particular expenditures. Therefore, budget incidence analyses change in distribution, which results from a simultaneous change in tax and expenditure policy.
Determinants of Tax Incidence
1. Elasticity:
The burden of tax can be shifted by agents by altering their behaviour in the market, which depends upon the flexibility to alter behaviour as measured by elasticities. Those with greater flexibility to alter their behaviour will be more able to shift the burden of tax to others. In terms of elasticity of demand and supply, if the demand for the commodity is elastic or the supply of the commodity taxed is inelastic, the incidence will be on the producer. Conversely, the incidence is on the consumer if the demand is inelastic or the supply is elastic.
2. Price:
As tax shifting is effected through price changes, the incidence of tax also depends upon the changes in price. If the price remains unchanged after the tax, then the tax cannot be shifted.
3. Time:
The incidence of a tax in the short run can be different from its incidence in the long run since the elasticity of demand and supply varies over time. In the short run, supply adjustment is constrained by the size of the plant. Therefore, supply remains relatively inelastic. Hence, the incidence of tax is on the producer in the short run, whereas in the long run, it is on the consumers as a full adjustment in supply can be effected through a change in the size of the plant.
4. Cost:
A tax can reduce the demand for the taxed commodity through a rise in price, which further can result in a change in the scale of production and, hence, the costs. The change in cost due to the change in the scale of production can result in shifting the burden of the tax. But the shift will depend upon whether the industry is decreasing, increasing or constant cost industry. For instance, in the case of a decreasing cost industry, the burden of the tax can easily be shifted to the consumer by reducing the scale of production, which will raise the cost and, hence, price. Consumers will bear the burden by paying the increased prices.
5. Nature of Tax:
The incidence of a tax is also determined by the nature of the tax, i.e. whether it is an indirect or direct tax. A direct tax cannot be shifted, whereas, in the case of an indirect tax, the burden is transferred through adjustment in prices.
6. Market Form:
The nature of competition in the market also affects the tax incidence. Under perfect competition, tax cannot be shifted as producers are price takers and cannot affect it, but under imperfect competition, it can be shifted to various extents depending upon the nature of imperfect competition or the degree of competition.
Incidence of Some Taxes
The theory of incidence explains the incidence of some popular taxes. For instance, payroll taxes are paid by the employer but are borne by the employees in the form of lower wages. The incidence of payroll taxes lies on the employee, and it is on lower-income workers much more than on higher-income workers. Producers mostly bear taxes on goods with close substitutes as the demand curve of such products is elastic. Property taxes cannot be shifted, and the incidence lies on the assessee. Similarly, income tax cannot generally be shifted.
Profit taxes are completely absorbed by the firm. Corporate tax can partly be shifted to buyers through price increases. Corporations in a competitive market bear the burden of income tax, whereas corporations with significant market power, like monopolists, pass on the burden of tax to consumers.
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