Who really pays a tax
Why a tax's burden is shared between buyers and sellers whoever hands it over, and why the less elastic side pays more.
FinanceA company's marketAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Work out the prices buyers pay and sellers receive after a tax
- Explain why it doesn't matter whether buyers or sellers are taxed
- Predict which side bears more of a tax from the elasticities
Builds toward: Judge a company. Read a company's accounts, apply Graham's tests, and make a rough valuation.
A company's market: pricing power, taxes and trade: lesson 6 of 15
- A company's market
- Price elasticity of demand 6 min
- Elasticity and total revenue 5 min
- Consumer and producer surplus 4 min
- Market efficiency 5 min
- Price ceilings and floors 6 min
- Who really pays a tax 5 min
- Deadweight loss 5 min
- How tax size changes the loss 5 min
- Absolute and comparative advantage 5 min
- Why trade helps both sides 5 min
- Winners and losers from trade 5 min
- Tariffs and quotas 5 min
- What makes productivity grow 5 min
- Growth policy 5 min
- Why unemployment exists 6 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 6
What it is
Tax incidence is how the burden of a tax is shared out. The surprise is that it doesn't depend on who the law says must pay.
A tax on sellers. Mankiw's town puts a 0.50 tax on each ice-cream cone, paid by sellers. Sellers now need 0.50 more at every quantity, so the supply curve shifts up by 0.50. The new equilibrium:
- The price buyers pay rises from 3.00 to 3.30: buyers are 0.30 worse off per cone.
- Sellers receive 3.30 but hand 0.50 to the government, so they keep 2.80: 0.20 worse off.
- The quantity falls from 100 to 90 cones: the tax shrinks the market.
A tax on buyers shifts the demand curve down by 0.50 instead. The result is the same: buyers pay 3.30 in all, sellers get 2.80, and 90 cones are sold. A tax drives a wedge between what buyers pay and what sellers receive, and the wedge is the same whichever side hands the money over.
Quick check
Tap an answer to check it.
After a 1.00 tax on sellers, buyers pay 5.60 instead of 5.00. What do sellers keep per unit?
- That is what buyers pay; sellers must pass 1.00 to the government
- That would mean sellers bear the whole tax
Show answer
4.60. 5.60 − 1.00 = 4.60, so sellers lose 0.40 and buyers 0.60.
Text description
Supply S1 and demand cross at a price of 3.00 and 100 cones. A tax of 0.50 on sellers shifts supply up by 0.50 to S2. The new equilibrium is at 90 cones. Buyers pay 3.30, up 0.30; sellers receive 3.30 but keep 2.80 after tax, down 0.20. The gap between 3.30 and 2.80 is the tax wedge.
Why it matters
Payroll taxes. US law splits the payroll tax for Social Security and Medicare (15.3% of earnings for the typical worker in 2010) half and half between firms and workers. Mankiw's point: lawmakers cannot decide the real split. A payroll tax is a wedge between the wage firms pay and the wage workers receive, and supply and demand decide who bears it.
Elasticity decides the split. The burden falls more heavily on the side of the market that is less elastic:
- If supply is elastic and demand inelastic, sellers can easily leave the market and buyers can't, so buyers bear most of the tax.
- If supply is inelastic and demand elastic, sellers bear most of it.
Mankiw's explanation: elasticity measures how willing people are to leave the market when conditions get worse. The side with fewer good alternatives is stuck, and pays more. For the payroll tax, he notes, most labour economists believe labour supply is much less elastic than labour demand, so workers bear most of it, whatever the law's half-and-half split says.
Worked example
A 2.00 tax per concert ticket. Before the tax, tickets sold for 40.
Case A: fans are devoted, so demand is inelastic. After the tax, buyers pay 41.60.
- Buyers' burden: 41.60 − 40 = 1.60 (80% of the tax).
- Sellers keep 41.60 − 2.00 = 39.60, so their burden is 0.40 (20%).
- Buyers bear most: demand is the less elastic side.
Case B: there is lots of other entertainment, so demand is elastic, and the venue has few other uses. After the tax, buyers pay 40.40.
- Buyers' burden: 0.40 (20%). Sellers keep 38.40: burden 1.60 (80%).
- Sellers bear most: supply is the less elastic side.
Common mistake
Believing that the side named in the law pays the tax. Whether the tax is collected from buyers or sellers, the prices adjust until both share it, in proportions set by the elasticities.
Key terms
- tax incidence
- how the burden of a tax is distributed among the people in a market
- tax wedge
- the gap a tax creates between the price buyers pay and the price sellers receive
- payroll tax
- a tax on the wages firms pay their workers
Practise the key terms
Tap a card to turn it over. 3 cards.
| Front | Back |
|---|---|
| tax incidence | how the burden of a tax is distributed among the people in a market |
| tax wedge | the gap a tax creates between the price buyers pay and the price sellers receive |
| payroll tax | a tax on the wages firms pay their workers |
Practice
Work it through
Before a 3.00 tax per unit, the price was 20. After the tax, buyers pay 21.00.
- 21 − 20
- 21 − 3
- 20 − 18
- 2 ÷ 3 × 100
Quick quiz
Tap an answer to check it.
In the last exercise, which side is less elastic?
- Buyers bear only a third
Show answer
Supply: sellers bear the larger share. The burden falls more heavily on the less elastic side.
The government moves a tax from sellers to buyers, at the same amount. What changes?
- The burden is shared in the same way as before
Show answer
Nothing in the end: the same wedge gives the same prices and quantity. Who hands over the money does not change the incidence.
Why does Mankiw say workers bear most of the payroll tax?
- The law splits it half and half; the market decides the real split
Show answer
Labour supply is much less elastic than labour demand. The less elastic side bears more of a tax.
In short
- A tax drives a wedge between what buyers pay and what sellers receive.
- Buyers and sellers share the burden, whichever side the law taxes.
- The less elastic side bears more.
- Mankiw: workers bear most of the payroll tax.
Mastery check
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Check yourself
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In Mankiw's example, what do buyers pay and sellers keep after the 0.50 tax?
Show answer
Buyers pay 3.30; sellers keep 2.80.
What happens to the quantity sold when a good is taxed?
Show answer
It falls: the tax shrinks the market (from 100 to 90 cones in Mankiw's example).
Demand is very inelastic and supply elastic. Who bears most of a tax?
Show answer
Buyers.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 6.
- On this site: Price ceilings and floors and Price elasticity of demand.
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