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Tax Incidence and How It Works

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Created on
May 9, 2023


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Every time you see an announcement of an increase in sales tax on a good, you should be wary because this can mean an increase in your tax burdens. Understanding tax incidence helps you assess how tax burdens get shared between producers and consumers and who bears the actual tax burden. 

To help understand this concept better, we cover the meaning of tax incidence, the difference between impact and incidence of tax, and how it works in the following sections.

Debunking Tax Incidence

Tax incidence is an economic term used to understand the division of a tax burden between various stakeholders, like buyers and sellers. It is an essential concept in understanding the difference between the impact and incidence of tax. The impact point is the initial point where the tax is imposed. For instance, if a tax is imposed on tea, the manufacturer is liable to bear the direct burden of this tax. 

As against this, tax incidence means the individual bears the final tax burden. For instance, the coffee manufacturer raises the product's price through tax shifting to pass the tax burden to the final consumer. 

How Does Tax Incidence Work?

While the incidence of tax refers to the impact and incidence of tax, to understand how it works, you will need to understand who finally shoulders the tax burden. So, calculating tax incidence is more about the final tax payment than who pays the tax directly. 

Tax incidence is linked to the price elasticity of demand and supply and, thus, varies between goods. Producers can easily transfer most of the tax burden on the customer for goods with inelastic demand (where demand doesn't change much with price changes). For instance, even if the price of petrol rises with a tax increase, people will keep buying this basic necessity. 

Conversely, producers will shift only a part of this tax burden for goods with an elastic demand (where demand changes significantly with slight price changes). For instance, if the price of jewellery and automobiles rise due to sales tax, people will postpone buying these items. So, the producer will try to absorb most of the tax burden to minimise price rise for these goods with relatively elastic demand. 

Calculating Tax Incidence 

If you know the price elasticity of demand and supply for a particular good, you can calculate tax incidence using the following formulas:

*Es - Elasticity of Supply

**Ed - Elasticity of Demand 

Note: While elasticity of demand and supply are crucial determinants of tax incidence, it also depends on other macro and micro factors. This makes computing tax incidence a complicated process. 

What Does It Mean for Me as a Consumer? 

Tax incidence defines the amount of tax shifted from the retailer or manufacturer to you as a consumer. Knowledge of tax incidence empowers you as a consumer and citizen. You can decide how proposed or enacted policy decisions affect your bottom line. 

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Frequently Asked Questions

What is an example of an incidence of tax?

The cigarette tax is imposed on retailers but gets shifted to the consumer. So the retailer pays the tax directly to the government but recoups the same from customers by increasing cigarette prices. 

What determines the incidence of the tax?

The price elasticity of demand and supply remain crucial determinants of tax incidence on a good. 

What are the types of tax incidence?

There are two types of tax incidence - statutory incidence and economic incidence. Statutory incidence is shouldered by the individual who pays the tax directly to the government, while economic incidence is shouldered by those who finally bear the actual tax cost. 

What are the principles of tax incidence?

Principles of tax incidence are based on the price elasticity of goods. Tax burdens for necessities with inelastic demand are easily shifted to the customer. In comparison, the producers absorb tax incidence for goods with high price elasticity of demand, limiting price rise.


Fi Money is not a bank; it offers banking services through licensed partners and investment services through epiFi Wealth Pvt. Ltd. and its partners. This post is for information only and is not professional financial advice.
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