Tax incidence
Based on Wikipedia: Tax incidence
Here's a counterintuitive fact that upends most people's assumptions about taxes: it doesn't matter who actually writes the check to the government. Whether a tax is collected from buyers or sellers, from employers or employees, from landlords or tenants—the economic burden falls where it falls, regardless of who physically hands over the money.
This insight, called tax incidence, is one of the most important and least intuitive ideas in economics.
The Butter Example
Imagine the government imposes a ten percent tax on butter, collected from sellers. You might assume the sellers bear that burden—after all, they're the ones writing checks to the tax authority. But watch what happens to prices.
If butter costs two dollars before the tax, and after the tax the price rises to two dollars and eight cents, then eighty percent of that tax has been shifted onto buyers. The sellers are only eating twenty percent of the cost. The tax was nominally on sellers, but buyers bear most of it.
This reveals the crucial distinction economists make between nominal incidence—who the tax is collected from—and real incidence—who actually ends up poorer because of it. The real incidence is what matters. It's measured by looking at how real incomes change after accounting for the way taxes ripple through prices.
Why It Doesn't Matter Who Pays
This might feel wrong. Surely if you tax sellers, sellers pay. If you tax buyers, buyers pay.
But think it through. When you tax sellers, they face higher costs and want to raise prices. When you tax buyers, their effective willingness to pay drops, pushing prices down. Either way, the tax creates a wedge between what buyers pay and what sellers receive. The size of that wedge is the same regardless of which side you collect from. The only question is where the new price lands within that wedge.
The mathematics confirms this. Graph it out: tax the sellers and the supply curve shifts left. Tax the buyers and the demand curve shifts left. Either way, you end up at the same equilibrium price and quantity. The pie shrinks by the same amount. The division of who loses how much depends on something else entirely.
The Elasticity Rule
So what does determine who really pays? Flexibility—or in economic jargon, elasticity.
Elasticity measures how much quantities change when prices change. If you're elastic, you're flexible. Raise the price on you and you'll buy less, or produce less. If you're inelastic, you're stuck. You'll keep buying or selling roughly the same amount no matter what prices do.
The fundamental rule of tax incidence is this: the burden falls most heavily on whoever is least able to escape it. The inelastic party—the one who can't easily change their behavior—gets stuck with the bill.
Think of it as a negotiation where one party has nowhere else to go. If consumers desperately need a product and have no substitutes, they'll absorb a tax by paying higher prices. If producers are locked into producing something regardless of price, they'll absorb a tax by accepting lower revenues.
A Tale of Two Apple Farmers
Imagine a one dollar per barrel tax on apples. What happens depends entirely on the nature of the apple market.
In the first scenario, consumers need their apples. Maybe it's a local market with no competition, or apples are a critical ingredient for regional cider makers who can't substitute. The farmer raises prices by the full dollar. Consumers grumble but pay. The farmer's income is unchanged; the tax falls entirely on buyers despite being collected from the farmer.
In the second scenario, consumers are fickle. Plenty of fruit options, easy to switch to pears. If the farmer tries to raise prices at all, sales collapse. The farmer has no choice but to eat the entire tax. Revenue drops by a dollar per barrel. The farmer writes the check to the government, and the farmer truly pays.
Most real markets fall somewhere between these extremes. Consumers bear some of the burden. Producers bear some. The split depends on relative elasticities.
Calculating the Split
Economists have a formula for this. If we call the price elasticity of supply PES and the price elasticity of demand PED (which is negative, since demand curves slope downward), then the fraction passed through to buyers is:
PES divided by (PES minus PED)
Say apple demand has elasticity of negative 0.4—fairly inelastic, people like their apples—and supply has elasticity of 0.5. The pass-through to buyers is 0.5 divided by (0.5 minus negative 0.4), which equals 0.5 divided by 0.9, or about fifty-six percent.
Buyers bear fifty-six percent of any apple tax. Sellers bear forty-four percent. This holds regardless of whether the government collects from buyers or sellers.
The Social Security Deception
This framework illuminates one of the great accounting fictions of American taxation. Social Security payroll taxes are nominally split fifty-fifty between employers and employees. Your pay stub shows the employee portion. Your employer pays a matching amount you never see.
This sounds like sharing. But economists generally find that workers bear almost the entire burden.
Why? Because labor supply is relatively inelastic. Most people can't easily opt out of working—they need income. Meanwhile, firms can adjust their compensation packages, substituting away from labor or moving operations. The result: when Social Security taxes rise, wages fall by approximately the full amount of both the employer and employee portions.
The employer "contribution" is an accounting fiction. It's money that would otherwise be your wages. The fifty-fifty split exists only on paper. In reality, the tax incidence falls overwhelmingly on workers.
The Direction of the Shift
Economists use the terms "forward shifting" and "back shifting" to describe which way tax burdens flow.
Forward shifting means producers pass the tax onto consumers through higher prices. This happens when demand is inelastic relative to supply—consumers are stuck, so they absorb the burden.
Back shifting means the tax flows backward onto producers and ultimately onto the factors of production they employ—workers, landlords, capital owners. This happens when supply is inelastic relative to demand—producers are stuck, so they absorb the burden.
Consider a tax collected from a producer who faces elastic consumers (many alternatives) but employs workers with few alternative job options. The producer can't raise prices without losing customers, so can't forward shift. But the producer can push back on wages. The tax incidence flows backward, ultimately landing on workers even though they never write a check to the government.
Extreme Cases
The principle becomes crystal clear at the extremes.
When supply is perfectly elastic—producers can supply any quantity at the same cost, like a small country buying capital from global markets—the entire burden falls on consumers. Producers simply won't supply unless they get their required price, so any tax gets fully passed through.
When demand is perfectly inelastic—consumers will buy exactly the same quantity no matter what, like certain life-saving medications—the entire burden again falls on consumers. They'll pay whatever is asked.
Flip those: when supply is perfectly inelastic—like raw land, which exists in fixed quantity regardless of price—the entire burden falls on suppliers. Landowners can't produce more or less land in response to taxes, so they absorb the full hit.
This last point is why economists since Henry George in the nineteenth century have noted that land taxes are uniquely efficient. Tax land and the landowner bears it fully; you can't distort the supply of something that's fixed. Tax labor or capital and people work less or invest less, shrinking the economy.
The Labor Market Case
Labor markets follow the same logic. It doesn't matter whether a payroll tax is imposed on employers or employees—the incidence depends on relative elasticities.
But labor markets have a twist. Some economists believe labor supply curves are "backward-bending" at high wages. The idea is intuitive: at low wages, higher pay motivates more work. But past some point, people value leisure more than extra income. Very high earners might work less if wages rise, preferring to buy back their time.
If this is true, taxes on high earners have an unexpected effect. By lowering effective wages, taxes might actually increase labor supply as wealthy workers put in more hours to maintain their lifestyle. The tax shifts the labor supply curve and, paradoxically, could increase work effort.
The Corporate Tax Puzzle
Corporate income taxes present the most complex incidence question, and economists remain genuinely uncertain about the answer.
The nominal burden falls on shareholders—corporations pay the tax from their profits. But capital is mobile. If corporate profits get taxed heavily, investors redirect money toward untaxed or lower-taxed uses: real estate, partnerships, foreign investments.
This capital flight has consequences. As capital flows away from corporate enterprise, the return on capital falls everywhere—not just in corporations. And as corporations have less capital to work with, worker productivity falls, which eventually means lower wages.
So who really pays the corporate tax? Shareholders initially. But over time, as capital adjusts: owners of non-corporate capital (who now earn less because of the increased competition from fleeing corporate capital). Workers (who have less capital to work with). Perhaps even consumers (if reduced corporate investment means fewer or more expensive goods).
Estimates vary wildly. Some economists conclude most of the burden stays with capital owners. Others find that workers bear a majority of corporate taxes in the long run. The honest answer is that nobody knows for certain—the flows are too complex and the data too noisy.
Why This Matters for Policy
Tax incidence analysis matters enormously for evaluating whether tax systems are progressive (taking more from the rich) or regressive (taking more from the poor).
A tax nominally imposed on corporations sounds like it hits wealthy shareholders. But if the true incidence falls largely on workers through lower wages, it's actually a tax on labor income—potentially quite regressive.
A payroll tax nominally split between employers and employees sounds balanced. But if workers bear both halves, the stated split is meaningless.
A sales tax nominally paid by businesses sounds like a corporate burden. But if it's passed fully through to consumers, it's really a consumption tax—likely regressive, since poor people spend a higher fraction of their income.
Without understanding incidence, you can't understand who really pays. And without knowing who really pays, you can't evaluate whether a tax system is fair.
The Deeper Lesson
Tax incidence teaches a broader truth about economics: formal designations often don't match economic reality. Who signs the check, who gets the bill, whose name appears on the form—these are legal facts, not economic ones.
Economic reality follows different rules. Burdens flow to whoever can't escape them. Costs settle on whoever has the fewest alternatives. The actual distribution of pain depends on the structure of the market, not the structure of the paperwork.
This applies beyond taxes. Minimum wage laws nominally require employers to pay more. But depending on labor market conditions, the true burden might fall on employers (lower profits), workers (fewer jobs), or consumers (higher prices). Rent control nominally caps what landlords can charge. But the incidence of the resulting housing shortage falls on would-be tenants who can't find apartments.
In every case, the question isn't who the law names as responsible. The question is who, when all the economic dust settles, ends up worse off. That's the incidence. And it almost never matches the paperwork.