What decides how a tax's burden is shared

Impact and incidence. The impact of a tax is on whoever must pay it to the government; its incidence (burden) is on whoever is actually made worse off by it. When a tax is put on a good, the price buyers pay rises and the price sellers keep falls, so the burden is normally shared by both, and it makes no difference whether the law collects the tax from the buyer or from the seller.

The answer: relative elasticities of demand and supply. How the burden is divided depends on the price elasticities of demand and supply:

• the share borne by sellers / the share borne by buyers = elasticity of demand / elasticity of supply;
• so the less elastic side bears the larger share. If demand is relatively inelastic, buyers bear most of the tax; if supply is relatively inelastic, sellers bear most of it.

Why: the side that cannot get away pays. A tax drives a wedge between the price buyers pay and the price sellers receive, and the market has to shrink until the wedge equals the tax. Which price moves more depends on who can respond by leaving the market:

• Inelastic demand. Buyers of a necessity cannot easily cut their purchases when the price rises, so sellers can pass most of the tax on; the price paid rises nearly by the full tax.
• Elastic demand. Buyers of a good with close substitutes switch away when the price rises, so sellers cannot pass the tax on and must absorb most of it in a lower price received.
• Inelastic supply. Sellers who cannot easily reduce output (for example perishable goods where storage is lacking) have to accept a lower price, so they bear most of the tax.
• Example (our own): a tax on life-saving medicines falls mainly on patients, whose demand is inelastic; a tax on one brand of cold drink falls mainly on its maker, because buyers simply switch brands.

Special cases. If demand is perfectly inelastic, the whole tax falls on buyers; if demand is perfectly elastic, the whole tax falls on sellers.

Conclusion. The burden of a tax is divided according to the relative elasticities of demand and supply, not according to who hands the money to the government: the side that is less able to change the quantity it buys or sells bears more of the tax.