Simple Economics on the Web

 Your handy guide to economics


Tax Incidence and Elasticity

We know from the two previous pages that a tax per unit - either a sales tax or a producer tax - will ultimately be divided between a higher price for consumers and a lower price for producers. But how much of the tax will fall on consumers and how much will fall on producers?

The answer depends on the relative elasticities of the supply and the demand curves. For example, if demand for a product is more inelastic than its supply - say a lifesaving drug - consumers will absorb higher prices with little change in what they buy. In this case, most of the tax will be paid by consumers and little will be paid by producers.

Conversely, suppose demand for a product is much more elastic than supply - say demand for houses in Pleasantville, a small town that is surrounded by other towns. If the Pleasantville government levies a large tax on apartment rents, it will be hard to pass this tax on to renters since they can rent in other nearby towns. Here most of the tax will be paid by the owners of the apartment buildings.

In the graph below, experiment with demand elasticity and supply elasticity to see how they determine the division - the" incidence: - of the tax. Begin by comparing extreme cases: a tax imposed on a life-saving drug (with very inelastic demand and elastic supply) versus the same tax imposed on apartment rents in Pleasantville (inelastic supply but elastic demand).

 

Created by Frank Levy and Myounggu Kang
Last Updated on September 26, 2003