The Meaning of Impact, Incidence and Shifting:
When a tax is levied, its first impact will be felt by the person, who actually makes the tax payment. He may be an income-receiver, property owner or a buyer or seller of goods arid services. He may bear the tax himself. In some instances, he may be able to shift the burden to someone else.
In either case, there will be a series of secondary effects of more or less economic significance. Acceptance of the burden of the tax by the original payer will affect his disposable income and therefore his demand for productive factors and for other commodities shifting the burden to someone else implies a change in disposable income of others.
Hence incidence of tax, whether it is shifted or not generates a series of effects. Now we can easily define the concepts. The impact of a tax is upon the person from whom the tax is first collected. It represents the immediate money burden of the imposition of the tax. It denotes the impingement of the tax on the person who first pays it.
Hence, the impact of a tax falls on the persons from whom the tax is collected. In a sense it is the first point of contact of the tax with the taxpayers. Impact of a tax is on the person, who pays the money in the first instance.
The incidence of a tax is upon the person who pays it ultimately. Suppose a tax is imposed upon a commodity imported from a foreign country. The government will collect the tax from the foreigner. But the foreigner will generally raise the price of the commodity on account of the tax. In some cases, he will recover the whole amount of the tax from the domestic consumer.
In these cases, the incidence of the tax is upon the domestic customer who ultimately pays the tax. Hence, incidence of a tax is defined as the final resting point of a tax.
Incidence of a tax is upon those economic units which finally bear the money burden of it and which are not able to pass on to others. The final resting point of the burden of tax is called the incidence. In the above example, the incidence of tax is on the final consumers.
By the tern shifting we mean the transference of the burden of a tax from the payer to some other person or persons. In the above mentioned case, the tax is said to be shifted to the consumer from the foreigner who pays the tax at first. The process of shifting is also called repercussion of taxes.
In general impact is the initial money burden, the shifting is the intermediate process and the incidence is the result.
Formal Incidence and Effective Incidence:
Mrs. Hicks makes a distinction between formal incidence and effective incidence. Formal incidence refers to the distribution of the total burden of the tax among individuals belonging to different classes in society.
She observes “calculation of formal incidence is of great social interest in connection with the questions of the distribution and redistribution of income; it is also of great economic importance to the government when planning the national output….”
Mrs. Hicks further states that formal incidence refers to the amount of a tax collected by the government”. The formal incidence of a direct tax will be on those who pay it in the first instance. The formal incidence of an indirect tax will be borne by those who buy the commodity concerned.
Effective incidence refers to the taxpayers’ reaction to the payment of a tax and its consequences. The variation in the distribution of consumer’s wants and incomes and allocation of factors brought about by the imposition and payment of a tax measures the effective incidence of that tax.
It usually includes the advantages and disadvantages which the economy derives from a tax system. It is impossible to estimate properly the effective incidence of a tax.
Forward Shifting and Backward Shifting:
A tax may be shifted either through a sale transaction or through a purchase transaction. The shifting of a tax will involve a change in the price of something from what it otherwise would have been.
Shifting is forward, when as with customs and excise, the transfer is from an earlier to a later stage in the productive process as from producers or importers to consumers. When the tax is shifted forward, the price which constitutes the vehicle for shifting will increase. Hence, when the seller shifts the tax to the consumer it is called forward shifting.
When a tax is shifted backward the price which constitute the vehicle for shifting, will decrease. Here, shifting takes place through purchase transaction. For example, a house tax may be levied from the tenant and deducted by him from his next payment of rent.
If a tax is levied on an article of consumption, the consumers may restrict their demands, if price rise. For fear of fall in demand, the seller or producer may choose to bear the burden himself. In that case the tax is shifted backward.
1. Tax Capitalization:
Shifting of a tax can be done by another method called tax capitalization. This is possible in the case of durable articles like land, house property, motor car etc. These durable articles are subject to periodic taxes.
Here the purchaser calculates the amount of taxes which he would have to pay on the property. The present values of such future payments are calculated and deduct this value from the price which he pays to the seller.
The purchase price should be reduced sufficiently to cover the tax. Then the purchase price of the item is reduced by a part of the full amount of that value. Such reduction of the purchase price by the purchase to cover the periodical tax payment is called tax capitalization. An illustration will make this point clear.
Suppose a house valued at Rs. 1 lakh, gives an annual income of Rs. 10,000/-. This income is taxed at the rate of 10% per annum. That is Rs. 1000/- per annum. Then net income from the house is Rs. 9000/- (Rs. 10,000 – Rs. 1000 = 9000). Thus the buyer will be willing to pay only Rs. 90,000/- (9000 x 100/10 = 90,000) to get a return of 10% on his investment.
Thus the tax on property is borne by the seller. In reality, the tax will have to be paid every year in future. Hence, all future annual incomes from his house minus annual tax payments are discounted at the current rate of interest. Then the value of the property is arrived at on the principle Rt – Tt/ (I + rt)t where Rt is return per year. Tt is tax payments and rt is the rate of interest.
For the realization of tax capitalization, some conditions are required.
Firstly, the tax must be exclusive or unequal.
Secondly, the commodity must have a capital value as for example, land or house, which are capable of having an annual income.
Thirdly, there must be a business transaction that is transfer of economic goods from one person to another. The commodity must be durable.
Shifting and capitalization are two methods of escape from the burden of taxation. However, Seligman argues that a tax can only be shifted when it is not capitalized.
Seligman observes “if a tax is capitalized, it cannot be shifted, that is capitalization and shifting are two different things altogether, for while in shifting, the owner or producer or importer transfers the tax to another and thus escape the loss; in capitalization on the other hand, the owner or producer himself incurs the capitalized tax in the decreased value of the wealth of which, he was the original owner or of the produce he sells”.
However, Seligman’s argument has been refuted by many fiscal theorists. As a matter of fact there is shifting in the capitalization process. The new owner is responsible to the government for the taxes levied and actually pays them, though he does not feel their burden because he has transferred them once for all to the original owner.
Hence, the essential elements of shifting are present in tax capitalization. In another sense tax is paid by one person and borne by another. In this sense also tax capitalization is a case of backward shifting.
2. Effects of Taxation:
Imposition and realization of taxes involves a variety of responses from the taxpayers. These responses influence the function of the economic system as a whole. Imposition of tax may generate both positive and negative influence on production, growth, saving, consumption, investment etc. in an economy. Effect is the resulting responses and changes in the economy.
The overall responses and results of a tax are collectively called the effects of tax. Effect is the resulting responses and changes in the economy, from the imposition of tax. The effect of taxation may be called its pressure.
Pressure may be exerted by the impact of the taxation, its shifting or from the incidence itself. The process of shifting creates real burden other than that of incidence upon the buyer. This is its effects. The minimum effect of a tax, when it is imposed may be the reduction in disposable income of the taxpayers. Effect of taxation is thus a wider concept.
If we consider not only changes in income available for private use, but include benefit from public services as well, we address ourselves to the more comprehensive concept of net burden or gain from the budget transaction as a whole.
Incidence then becomes one of determining the distributional impact of net benefits combining
(a) Resulting changes in the distribution of income available for private use and
(b) Distributional impact of the benefit from public services. In the end it is this net effect that matters significantly.
It is argued that a consideration of tax burden without inclusion of expenditure benefits remains a one-sider approach, just as a consideration of expenditure benefits without allowance for accompanying tax burden.
If tax revenue is used to provide additional public services, resources are transferred from private to public use. Then the benefit from public use must be balanced against the loss of reduced private use of resources.
If the budget process is planned efficiently, the value of these benefits at the margin is equal to that of loss in reduced private consumption. However considering the entire transaction, there will be a net gain.
Similar considerations apply when tax revenue is used to finance a transfer payment. In this context, no resource transfer to the public sector occurs, but the distribution of private income is changed. Net gain will result if the additional income of transfer recipients is valued more highly from a social point of view than are the losses to taxpayers.
Measurement of Incidence:
Now we come to the typical case of differential tax incidence and see how resulting changes in distribution are to be measured. Tax substitution process under the budgetary policy change, will improve the position of some households and worsen that of others.
Changes in the position of any one household may be measured in terms of the resulting changes in its real income. Real income may change because of either a change in disposable income or a change in the price of the products which are purchased.
The disposable real income of the household may be defined as:
DRY = E-Ty/ P + Ts = DY/GP
Where ‘E’ is the earnings, ‘Ty’ income tax, ‘P’ is the price (at factor cost) of product bought and ‘Ts’ is the sales tax addition thereto. ‘DY’ is disposable income or after tax money income and GP is the gross price or market price.
We can find out how ‘DRY’ is subject to both direct and indirect effects. The primary effect of a tax change, which will operate on the earnings or source side of the household account, will change ‘Ty’, whereas primary effect which operates on the expenditure side use sie will change ‘Ts’.
Hence an increase in income tax lowers ‘DRY’ via an increase in ‘Ty’ a hence a fall in ‘DY’. An increase in sales tax lowers ‘DRY’ through an increase in ‘Ts’ and hence in ‘GP’.
In addition, there may occur secondary changes from the earning side or in ‘E’ and in secondary changes from the use side or in ‘P’. Even though, such secondary changes is of great importance to particular households, it will not result in a systematic offset to such changes in the size distribution of ‘DRY’, as caused by primary effect.
Measure of Change in Distribution:
When we view the problem of incidence in terms of effects upon the size distribution of income, we can measure the incidence by comparing the state of distribution before and after the particular tax change. Such a comparison is illustrated in figure No. 4.5.
Cumulative percentage of households is measured along the horizontal axis and percentage of disposable income (cumulative) is measured along vertical axis.
The curve OAB shows the percentage of income received by the lowest 10, 20, 30 etc. percentage of households. Thus the lowest 20 percent of households receives 8% money income and the lowest 80% receives 60%, leaving 40% for the highest 20% of households.
If distribution were equal, curve OAB world coincide with the straight line OB. Given a state of unequal distribution, the ratio of the two areas OABC/OBC may be taken as the index of equally. It will equal to one, if the distribution of income is totally equal.
Suppose that a change in tax policy is initiated, to cause a change in distributional pattern. Owing to the change, the new distribution pattern assumes OA1B. This means that income distribution has become equal.
Since OA1 BC/OBC > OABC/OBC, in this sense, the effect of the tax change has been progressive. Hence a moderately progressive level of taxation may have a greater impact upon the distribution of income. In this way the ratio, of co-efficient of equality before and after the budgetary change measure the incidence or distributional change.