Tax Incidence Theory

Tax Incidence Theory examines who actually bears the burden of a tax—whether it’s paid by consumers through higher prices or by producers through lower revenue. When a tax is introduced, the way it affects prices and income depends on the relative elasticity (sensitivity) of supply and demand. If demand is inelastic, consumers bear more of the tax burden since they will buy similar amounts regardless of price changes. Conversely, if supply is inelastic, producers absorb more of the tax because they cannot easily reduce production. The theory helps understand the true economic impact of taxes beyond who officially writes the check.