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Tax Incidence: Definition, Formula & Example

Tax Incidence: Definition, Formula & Example
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  • 0:03 What is Tax Incidence?
  • 1:12 Inelastic and Elastic Demand
  • 2:51 Determining Tax Incidence
  • 3:46 Tax Incidence Example
  • 5:10 Lesson Summary
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Lesson Transcript
Instructor: Adam Gifford
In this lesson, we'll define the concept of tax incidence. We'll also review the factors needed to determine tax incidence as well as look at the formula for tax incidence and review an example of how it's determined.

What Is Tax Incidence?

Karen is addicted to cigarettes. She smokes a pack a day and has no plans to quit. The state where Karen lives just added a $1 tax to every pack of cigarettes sold. Due to her addiction, she is willing to pay the extra cost in lieu of reducing her consumption of cigarettes. Karen is also in her second year of graduate school. She has just started her fall semester and needs to purchase an expensive textbook for her Advanced Corporate Finance course. The cost of the textbook at the campus bookstore is $200 plus 7% sales tax, for a total cost of $214. Karen decides to purchase the textbook from an online retailer that is based out of state and therefore doesn't charge the state sales tax. She gets the textbook for $200.

In both examples, Karen has to deal with a tax on a product that she wishes to purchase. However, despite the fact that she is the consumer, Karen isn't necessarily the one who is paying the tax incidence. Tax incidence is the division of tax payment between the buyer and seller. It is used to analyze who, between the buyer and seller, is really paying the tax.

Inelastic and Elastic Demand

Karen will pretty much buy the same number of cigarettes each day regardless of their cost because of her addiction. This is an example of inelastic demand. With inelastic demand, a consumer's demand is unaffected by changes in price. When inelastic demand occurs, it's the consumer who is paying the tax.

However, Karen will try to save as much money on her textbook as she can. In our example, she chose to purchase her textbook online because it was $14 cheaper than the one in the bookstore due to the sales tax. This is an example of elastic demand. With elastic demand, a consumer's demand is highly affected by changes in price. When elastic demand occurs, it is the seller who is paying the tax. In this case, the campus bookstore saw a decrease in demand for the textbook, which was caused by the sales tax. The bookstore paid the tax in the form of fewer textbook sales.

The same is true from the producer's end. If a product has inelastic demand, producers will continue to make the same amount of that product regardless of price. Cigarette manufacturers will continue to produce the same amount regardless of how high cigarette taxes are because people will continue to consume the same amount. This is known as inelastic supply. If a product has elastic demand, producers will vary their production with changes in price. This variance in production is referred to as elastic supply. Textbook sellers will need to lower their prices to compete with online sellers. If the bookstore lowered its price of the textbook to $186, the final price after tax would be just $199.02.

Determining Tax Incidence

Most products are somewhere in the middle of being completely inelastic and completely elastic. This means that the tax incidence will be divided between the buyer and seller. To determine how the burden of tax will be divided, you will need to know two things:

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