Maybe the consumer has a strict $100 budget, so, accounting for sales tax, they decide to leave out an item and purchase $80 worth of clothing, plus pay $4 in sales tax. In this scenario, the retailer arguably bears more of the tax burden, because the consumer is purchasing $20 less in merchandise. In other instances, consumers might be affected by certain taxes more than retailers. Perhaps higher business taxes lead a store to raise prices, thereby causing consumers to feel the effect of those taxes more. That can particularly be the case if price elasticity—or the percentage change in quantity when a price changes by 1%—is a factor. If something is a necessity, it could be inelastic, meaning consumers will still purchase the same amount, even if the price goes up. Yet if something is elastic (for example, a non-necessity like some consumer electronics) then consumers might decide to purchase less as the price goes up, meaning retailers might feel the incidence of higher business taxes.
How Does Tax Incidence Work?
Tax incidence works by determining who ultimately bears the cost of a tax rather than looking at who pays the tax directly. Figuring out this burden isn’t necessarily easy. Economists can apply different types of models to try to determine tax incidence, but the answer may not be clear-cut, even for them—especially because multiple factors may be at play at once. For example, a fall in consumer purchasing following a rise in sales taxes may be correlated, but perhaps the cause has more to do with broader economic conditions. In that case, the tax incidence might be overstated. At other times, however, it may be possible to more narrowly isolate cause and effect in taxation. For instance, some jurisdictions have sales tax holidays, when there’s no sales tax on purchases below a given dollar amount for a short period. In these cases, it may be possible to see how the lack of sales tax affects purchasing behavior, which can indicate who bears the cost of the tax. If retailers earn far more revenue during these sales-tax holidays, that could mean they’re shouldering at least some of the cost of normal sales taxes, rather than just the consumer who’s paying these fees. Still, the results can be somewhat muddled, as consumers may shift some normal purchasing from regular tax periods to sales-tax holidays.
What Does Tax Incidence Mean for Individuals?
Individuals, particularly those who have some sort of policymaking role, should consider tax incidence to get a more complete picture of the cost of adjusting taxes. You may be in favor of some taxes on paper, but when you look at who’s ultimately paying the cost, maybe you realize there are some unintended consequences. Instead, consider a tax that has a more direct incidence on the party who’s actually paying the tax upfront, which might seem more equitable. Tax incidence can be relevant when engaging in policy issues, such as when you write your local congressional representative about one of their positions. You also may want to consider tax incidence if you think a tax policy under consideration will end up having a significant unintended effect on someone who’s not directly being taxed.
