Government taxes and subsidies impact how costs and benefits are shared between consumers and producers. This topic explores who bears the burden and why it matters.
What is tax incidence?
Tax incidence refers to the distribution of the economic burden of a tax between consumers and producers in a market. While governments may legally impose taxes on either buyers or sellers, the true burden of the tax depends on market conditions, not on who writes the check to the government.
A tax may lead to a higher price for consumers and a lower price received by producers.
The difference between the price buyers pay and the price sellers receive is the per-unit tax amount.
The economic incidence refers to how this burden is split, regardless of which party pays the tax to the government.
The legal incidence is who is obligated to submit the tax payment (e.g., producers, retailers, or consumers).
Understanding tax incidence is important because it shows who is actually affected by taxation, which influences behavior, production, and consumption in the market.
The role of elasticity in tax incidence
The key factor that determines tax incidence is elasticity—specifically, the price elasticity of demand and the price elasticity of supply.
Price elasticity of demand
The price elasticity of demand (PED) measures how much the quantity demanded of a good changes in response to a change in price.
Elastic demand means that consumers are very responsive to price changes. A small price increase leads to a large drop in quantity demanded.
Example: luxury goods, expensive electronics.
Inelastic demand means that consumers are less responsive to price changes. They continue to buy nearly the same quantity even if the price rises.
Example: gasoline, cigarettes, insulin.
Price elasticity of supply
The price elasticity of supply (PES) measures how much the quantity supplied changes in response to a change in price.
Elastic supply means that producers are very responsive to price changes. They can increase output quickly when prices rise.
Example: manufactured goods, clothing.
Inelastic supply means that producers cannot easily change their output when prices change.
Example: agricultural goods in the short run, land, artwork.
General rules of tax incidence
The relative elasticities of supply and demand determine how the burden of a tax is shared:
The side of the market that is more inelastic bears a greater share of the tax burden.
This is because inelastic buyers or sellers have fewer alternatives and cannot avoid the tax by changing their behavior.
If demand is more inelastic than supply:
Consumers bear a larger share of the tax.
If supply is more inelastic than demand:
Producers bear a larger share of the tax.
This rule holds whether the tax is levied on the buyer or the seller. The actual outcome is determined by the market’s responsiveness to price changes, not by who pays the tax to the government.
Real-world examples of tax incidence
Gasoline tax
The demand for gasoline is highly inelastic in the short run—people need to fuel their cars regardless of price.
The supply of gasoline is more elastic, especially in global markets with multiple suppliers.
When a tax is imposed, most of the burden falls on consumers, who end up paying higher prices at the pump.
Luxury car tax
Luxury cars are price-elastic goods—buyers can easily postpone purchases or switch to less expensive alternatives.
The supply of luxury cars is often less elastic, particularly for imported models or limited editions.
When taxed, sellers absorb more of the tax burden, lowering their prices to avoid losing customers.
Cigarette tax
Cigarettes have very inelastic demand due to addiction and few close substitutes.
Supply is relatively more elastic, especially for large tobacco producers.
As a result, most of the tax burden is passed on to consumers, leading to significantly higher retail prices.
These examples show how different markets respond to taxes based on the elasticity of supply and demand.
Graphical analysis of tax incidence
To illustrate tax incidence graphically, economists use standard supply and demand diagrams.
A specific tax shifts the supply curve upward (if the tax is on producers) or the demand curve downward (if the tax is on buyers) by the amount of the tax.
This creates a wedge between the price consumers pay and the price producers receive.
The vertical distance between the original and new supply curve equals the per-unit tax.
The equilibrium quantity falls, and there is a reduction in total surplus.
Case: inelastic demand and elastic supply
The demand curve is steep (inelastic), and the supply curve is flat (elastic).
Buyers are less responsive to price changes than sellers.
Buyers bear most of the tax burden in this case.
Case: elastic demand and inelastic supply
The demand curve is flat (elastic), and the supply curve is steep (inelastic).
Sellers are less able to adjust quantity supplied.
Producers bear most of the tax burden in this scenario.
Students should label the following when drawing tax incidence graphs:
Original equilibrium price and quantity
New price paid by consumers (above the equilibrium)
New price received by producers (below the equilibrium)
Tax wedge (the vertical gap between the two prices)
Quantity exchanged after the tax
Government revenue (shaded area between the curves)
Numerical examples of tax incidence
Let’s work through two numerical examples to illustrate tax incidence in action.
Example 1: Equal burden
Original equilibrium price: 4 per-unit tax on sellers
After tax:
Price buyers pay: 8
Quantity falls to 90 units
Government revenue = 90 units × 360
Result:
Buyers pay 2 tax burden per unit
Sellers receive 2 tax burden per unit
The burden is shared equally between consumers and producers
Example 2: Using elasticity to estimate burden
Assume:
Price elasticity of demand = 0.2 (inelastic)
Price elasticity of supply = 1.5 (elastic)
Government imposes a 20
Quantity sold: 200 units
Government offers a 18
Price sellers receive = 18 from buyers + 5 = 2 per unit → consumer benefit
Sellers earn $3 more per unit → producer benefit
Now, use elasticity to estimate how the benefit is divided.
Assume:
Price elasticity of demand = 1.2
Price elasticity of supply = 0.4
Formula to calculate benefit share:
Consumer’s share = PES / (PES + PED)
Producer’s share = PED / (PES + PED)
Plug in the values:
Consumer’s share = 0.4 / (0.4 + 1.2) = 0.4 / 1.6 = 25%
Producer’s share = 1.2 / 1.6 = 75%
Interpretation:
Consumers receive 25% of the subsidy benefit
Producers receive 75%
Because supply is inelastic, producers capture most of the gain
Understanding subsidy incidence helps policymakers design more effective and equitable subsidy programs that target the intended beneficiaries.
FAQ
Yes, in extreme cases of elasticity, the entire burden of a tax can fall on either the consumer or the producer. If demand is perfectly inelastic (a vertical demand curve), consumers will bear 100% of the tax because their quantity demanded doesn’t change regardless of price. A real-world example is a life-saving drug with no substitutes—patients will buy it no matter how expensive it becomes, so suppliers can pass the full tax onto them through higher prices. On the other hand, if supply is perfectly inelastic, producers bear 100% of the tax burden because they cannot change the quantity supplied. A vertical supply curve indicates that the quantity is fixed, such as a limited number of rare art pieces. In this case, producers must absorb the tax without changing output or price. While these situations are theoretical extremes, they help illustrate how elasticity directly determines the tax incidence.
The time horizon plays a crucial role in determining elasticity and, therefore, the incidence of a tax. In the short run, supply and demand tend to be more inelastic, as producers and consumers have limited ability to adjust their behavior. For example, a gas tax in the short run affects consumers more because they can't quickly switch to alternatives like electric vehicles or public transport. As a result, consumers bear more of the burden in the short term. However, in the long run, both consumers and producers have more flexibility. Consumers can adjust by finding substitutes or reducing usage, while producers can alter production methods, enter or exit markets, or change inputs. As supply and demand become more elastic over time, the incidence of the tax may shift more toward producers if consumers successfully reduce demand. Therefore, tax incidence is dynamic and can evolve depending on how the market adjusts over time.
Governments often place taxes on goods with inelastic demand because consumers continue purchasing them even when prices rise, making such taxes a reliable source of revenue. For example, taxes on cigarettes, alcohol, and gasoline are common because demand for these goods is relatively unresponsive to price changes. Even with higher prices, people tend to purchase similar quantities due to addiction, necessity, or lack of alternatives. This allows the government to maximize revenue with minimal reduction in quantity sold, reducing the size of the deadweight loss. Additionally, such taxes are sometimes used for policy purposes—to discourage harmful behavior or fund related public services, such as healthcare costs from smoking-related illnesses. However, because these taxes often fall more heavily on lower-income groups, they may be considered regressive, raising concerns about equity. Policymakers must weigh the efficiency and revenue benefits against the potential social consequences of such taxation.
Businesses must consider tax incidence when setting prices and making strategic decisions, especially in competitive markets. If a firm operates in a market where demand is relatively inelastic, it can pass a larger portion of a tax onto consumers without significantly losing sales. In this case, firms might maintain profit margins despite higher costs. However, if demand is elastic, raising prices due to a tax could lead to a substantial drop in quantity demanded, harming revenue. In such markets, producers often absorb more of the tax to keep prices attractive, reducing their profit margins. Businesses also analyze supply elasticity—if their inputs are inelastic in supply, costs may rise faster, and absorbing taxes becomes harder. In response, firms may seek more cost-efficient production, shift supply chains, or lobby for exemptions. Understanding tax incidence helps firms forecast changes in consumer behavior, estimate demand loss, and adjust pricing strategies to remain competitive.
Unit taxes are fixed amounts per unit sold (e.g., $2 per pack of cigarettes), while ad valorem taxes are a percentage of the price (e.g., 10% sales tax). The incidence of both depends on elasticity, but their effects differ in magnitude and variability. With a unit tax, the tax amount is constant regardless of price, meaning it creates a uniform wedge between the price buyers pay and the price sellers receive. The higher the price elasticity, the more market behavior adjusts, and the more pronounced the deadweight loss. In contrast, ad valorem taxes scale with the price, so the tax burden increases with more expensive goods. This can have a larger behavioral impact on luxury items with elastic demand, as consumers are more sensitive to percentage-based price increases. Over time, ad valorem taxes can generate more revenue from inflation or rising prices, while unit taxes might require periodic adjustment to keep up with economic changes.
Practice Questions
Suppose the government imposes a per-unit tax on a good. Explain how the relative price elasticities of supply and demand determine the tax incidence. Use an example to support your answer.
The tax incidence depends on the relative elasticities of supply and demand. The side of the market that is more inelastic bears more of the tax burden. For example, if demand is inelastic and supply is elastic, consumers will bear most of the burden because they are less responsive to price changes and will continue buying despite higher prices. Conversely, if supply is inelastic and demand is elastic, producers bear more of the burden. For instance, with a tax on gasoline—where demand is inelastic—consumers end up paying most of the tax through higher prices.
A government introduces a $6 per-unit subsidy on a product. Demand is elastic, and supply is inelastic. Illustrate how the subsidy will affect the market and who benefits more from the subsidy.
When a subsidy is introduced, the supply curve shifts downward by the amount of the subsidy. Because supply is inelastic and demand is elastic, the majority of the subsidy benefits producers. This is because inelastic suppliers cannot easily change the quantity they supply, so they capture a greater share of the financial gain. Consumers benefit less, as they are more responsive to price changes and only moderately increase quantity demanded. As a result, producers receive a higher effective price for their goods, and consumers pay a lower price, but the larger share of the subsidy goes to producers.
