What decides how a tax burden is shared between buyers and sellers

Impact and incidence. The impact of a tax is on the person who hands the money to the government; its incidence (burden) is on whoever ends up worse off because of it, through a higher price paid or a lower price received. The two need not be the same person.

Who is legally taxed does not decide the burden. Suppose the government levies a tax of ₹10 a unit. If sellers must pay it, the supply curve shifts up by ₹10; if buyers must pay it, the demand curve shifts down by ₹10. In either case a wedge of ₹10 opens between the price buyers pay and the price sellers keep, the quantity traded falls, and the market settles at the same quantity and the same two prices. Whether the tax is imposed on the buyer or on the seller, its burden is shared by both.

The answer: relative elasticities. What decides the split is the price elasticity of demand compared with the price elasticity of supply. The share of the tax borne by each side is inversely proportional to its elasticity:

(burden on buyers) / (burden on sellers) = e(s) / e(d),

where e(s) is the elasticity of supply and e(d) that of demand (absolute value). So:

• if demand is less elastic than supply, buyers bear most of the tax;
• if supply is less elastic than demand, sellers bear most of the tax;
• if the two are equally elastic, the burden is split equally.

Why elasticity decides the split. A tax drives the two prices apart, and each side tries to avoid it by buying or selling less. Elasticity measures how easily a side can do that.

• Buyers with inelastic demand (few substitutes, a necessity) keep buying even at a much higher price, so sellers can pass most of the tax on to them; a large rise in the buyers' price is needed to cut their purchases.
• Sellers with inelastic supply (a fixed stock, specialised plant, a crop already harvested) cannot easily cut production or move into another line, so the price they receive has to fall by most of the tax.
• The side that can walk away more easily, the more elastic side, shifts the burden onto the other. Burden therefore falls on the side less able to change the quantity it buys or sells.

Our own example: a tax of ₹10 a cylinder on cooking gas. Households' demand is very inelastic (there is no easy substitute for daily cooking), so with fairly elastic supply the price paid might rise by about ₹8 and the price kept by sellers fall by about ₹2: buyers bear about four-fifths of the tax, as e(s)/e(d) = 4 would imply.

Special cases.

• Perfectly inelastic demand: the whole tax falls on buyers; the price rises by the full tax.
• Perfectly elastic demand: the whole tax falls on sellers, since buyers will not pay a rupee more.
• By the same reasoning, perfectly inelastic supply puts the whole tax on sellers, and perfectly elastic supply puts it all on buyers.

Conclusion. The burden of a tax is divided according to the relative elasticities of demand and supply, not according to who is legally made to pay it. The side whose quantity responds less to price (the less elastic side) bears the larger share, because it is less able to escape the tax by changing how much it buys or sells.