David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

4.9 Who really pays the tax?
S'
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GI
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GI
100
GI
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95
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A.
S'
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D'
01 Oo
Quantity
(a) Steep demand, flat supply
01 Oo
Quantity
(b) Flat demand, steep supply
Figure 4.7
Tax incidence
Either way, what we want to know is who ends up paying the tax. Suppose for simplicity we imagine a
packet of cigarettes costs £1 and the government imposes a specific tax of SOp per packet. Do smokers end
up paying the tax, or is it borne by cigarette producers? How much of the tax can producers pass on to the
consumer? We now show that this depends on the slopes of the supply and demand curves.
Figures 4.7(a) and 4.7(b) plot the (after-tax) price to the consumer on the vertical axis. DD' shows the
demand curve, which depends on the price to smokers (consumers). Since the price received by the
producer is the consumer price minus the SOp tax per packet, the effect of the tax is to shift the supply
curve from SS to S'S' in both diagrams. Each possible quantity supplied depends on the price received by
the producer, which will be the same as before only if consumer prices are SOp higher: that is why we must
shift the supply curve up by SOp.
In Figure 4.7(a), with a flat supply curve and steep demand curve, the tax is borne mainly by cigarette
consumers. Point B is nearly SOp higher than point A. Since demand is insensitive to price, producers can
pass on most of the tax in higher prices. Supply is price-sensitive, so the price received by producers cannot
fall much. Consumers pay £1.4S and producers get £0.9S a packet.
In Figure 4. 7(b ), with a flat demand curve and a steep supply curve, most of the tax is borne by cigarette
producers. Demand is price-sensitive, so attempts to pass on the tax in higher prices quickly lead to a drop
in sales. Supply is price-insensitive and producers hardly cut back even though the price they receive has
fallen nearly sop. Consumers pay £1.0S and producers get £0.SS a packet.
The key implication is thus that the incidence of a tax - who eventually bears the
burden - has nothing to do with who initially hands over money to the government.
The existence of the tax changes behaviour. This has induced effects on equilibrium
price and quantity. These induced effects may be large or small, depending on the
slopes of supply and demand curves.
The incidence of a tax
describes who eventually bears
the burden of that tax.
Now that we understand the general principle, it is obvious that the same argument will carry over to the
more commonly used ad valorem taxes. We simply need to remember to confront the change in the
percentage tax rate with the relevant percentage measures of price responsiveness of supply and demand,
namely the (own-price) supply and demand elasticities.
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