Explain the determination of incidence of taxation by the demand and supply analysis.
Explain the determination of incidence of taxation by the demand and supply analysis.
Or
Discuss Demand & supply theory of incidence of taxation.
Ans.
Demand and supply theory of tax incidence and shifting is based upon the marginal analysis of value and price. It is so because shifting is of tax burden can only be possible through raising prices. In other words, price is the vehicle through which tax burden can be shifted. Since prices are determined by the interaction of demand and supply, according to this theory incidence of a tax is determined by the demand and supply of the commodity on which tax is imposed. Shifting of a tax implies that burden of the tax entirely shifts from one person to another i.e., from seller to buyer or partially shifts from one person to another. To what extent burden of a tax will fall on the buyer and to what extent the burden of a tax falls on the seller depends on many factors such as (i) nature of a tax, (ii) elasticity of demand, (iii) elasticity of supply, (iv) nature of the market, (v) cost conditions etc. These factors have been discussed below.
(1) Nature of the Tax : Shifting of taxation by a firm depends upon the nature of the tax; that is, whether the tax is treated as a part of the fixed cost or variable cost. A tax imposed on the building of a factory premises or levied in the form of Licence Tax, is a part of the fixed cost and is independent of the volume of production. It has no effect on the marginal cost, marginal revenue and optimum production. As a result of such taxes, price of the commodity is not affected in the short period. Accordingly, in the short period the tax burden is not shifted. The producer himself will bear the burden of taxation even in the long run provided he is not incurring losses. In the situation of losses, tax will become a part of the average cost. Long term prices and average costs ought to be equal. So, tax amount will be included in the price.
(2) Elasticity of Demand: Elasticity of demand also affects shifting. If demand for the commodity is elastic, most of the tax burden will be borne by the seller or producer. Commodities with elastic demand will have a low demand if their prices increase. Low demand will reduce revenue (and therefore profits) of the producers. Accordingly, they may not like to increase the price. Contrary to it, if the demand for a commodity is inelastic, most of the tax burden will be shifted on to the consumers. Let us assume the demand for Dalda (Vegetable oil) as inelastic. If the prices of Dalda goes up due to tax, no significant fall in demand will occur. In such a situation the producer will like to add the tax amount in the price of Dalda and thus shift the incidence of taxation on to the consumers. In the words of Prof. Dalton, “Other things being equal, the more elastic the demand for the object to be taxed the more will be the incidence of the tax upon the seller and vice versa.” Figs. illustrate different situations of elasticity of demand and their effect on shifting.
(a) Unitary Elastic Demand (e=1): If the elasticity of demand is unitary, the increase in prices by taxation, will equally affect the sellers and buyers.
(b) Less Elastic Demand (e<1): If the demand for a commodity is less elastic (e<1), much of the tax imposed on it will have to be borne by the buyer. Fig. 2 illustrates this situation.
(c) More Elastic Demand (e> 1): When the demand for a commodity is more elastic, the burden of tax will have to be borne more by the producer than by the buyer.
(d) Perfectly Elastic Demand (e=∞): If the demand for a commodity is perfectly elastic, the entire burden of tax will be on the seller.
(e) Perfectly Inelastic Demand (e=O):
(3) Elasticity of Supply : Incidence of taxation also depends on the elasticity of supply of the commodity. More elastic the supply of commodity, greater is the final burden of tax on the buyers. In the long run, normally, the supply of a commodity is perfectly elastic because the producers generally get only the normal profits. Taxation increases the cost of production. Accordingly, the producers will not get even the normal profits. They are bound to decrease the size of output. Low production results in low supply. Low supply causes an increase in price, corresponding to a new point of equilibrium. In such situations the producer is successful in shifting the whole of the tax on to the buyer. In short period, the supply of a commodity is inelastic. The producers may be getting abnormal profits. Accordingly, they may share the burden of tax. However, in case of a perfectly elastic supply, the entire burden of taxation is to be borne by the buyer, while in case of a perfectly inelastic supply the entire burden is to be borne by the producer.
