Elasticity and tax incidence: the less elastic side bears more of the tax

Incidence of a tax. The impact of a tax is on the person who hands it to the government; its incidence is on those whose position is actually made worse. A tax raises the price buyers pay and lowers the price sellers keep, so its incidence is normally shared by both, and it does not matter whether the law makes the buyer or the seller pay it.

The relation in one rule. How the burden is shared is decided by the price elasticities of demand and supply:

burden on sellers ÷ burden on buyers = elasticity of demand ÷ elasticity of supply.

So the less elastic side of the market bears the larger share. Relatively inelastic demand puts most of the tax on buyers; relatively inelastic supply puts most of it on sellers.

Why elasticity decides the split. After the tax, the market settles where the gap between the buyers' price and the sellers' price equals the tax. Which of the two prices moves more depends on who can get out of the way of the tax:

• Demand. If buyers have no good substitute, they keep buying at a higher price, so sellers can pass most of the tax on to them; if buyers can switch easily to other goods, sellers cannot raise the price much and must absorb most of the tax themselves.
• Supply. If sellers cannot easily cut output or move their resources elsewhere, they have to accept a lower price and bear most of the tax; if they can readily reduce supply, the price received falls little and buyers bear more. In short, elasticity measures the ability to respond to a price change, and the side less able to respond is left holding the tax.

The extreme cases. With perfectly inelastic demand the whole tax falls on buyers; with perfectly elastic demand it falls entirely on sellers.

Illustration (our own). A tax of ₹6 a unit is put on a good whose demand has elasticity 0.5 and whose supply has elasticity 1 at the market point. Sellers' share ÷ buyers' share = 0.5 ÷ 1 = 1 ÷ 2, so buyers bear ₹4 and sellers ₹2 of the tax. If instead demand had elasticity 2 and supply 1, the ratio would be 2 ÷ 1, and buyers would bear ₹2 and sellers ₹4. So a tax on insulin, which diabetic patients cannot do without, falls mostly on buyers; a tax on one brand of bottled iced tea, which buyers can replace with another brand, falls mostly on its maker.

Conclusion. Tax incidence depends on relative elasticities, not on who is legally required to pay: the burden falls more heavily on whichever side, buyers or sellers, is less elastic, that is, less able to change the quantity it buys or sells when the price changes.