Friday, 1 August 2008

When Taxes Change, Who Pays?

"Tax incidence" is the analysis of who actually bears the burden of a tax.

In setting any tax policy it is important to assess how a given tax affects those involved in a given transaction. In general, the tax incidence is split between the producer and consumer. This is in contrast to the 'flypaper theory' of tax incidence which naively assumes that the tax sticks wherever it first lands.

An explanation of tax incidence can be found on Wikipedia, where there are graphs showing the effects on different elasticities of supply and demand (i.e. how much increased prices cause a drop in demand, or an increase in production). There is also a good explanation at the Institute for Fiscal Studies which looks uses the important example of the effect of a Vodka Tax.

Here, I'll have a look at the current situation of taxes on road fuel.

[TODO: look up research on elasticity, and see if I can quantify the situation. Supply seems rather inelastic, hence massive variation in price as demand rises and falls]