Top 4 Theories of Tax Shifting

This article throws light upon the top four theories of tax shifting. The theories are: 1. Concentration Theory 2. The Diffusion Theory 3. Demand and Supply Theory of Incidence 4. Musgrave’s Approach.

Tax Shifting # 1. Concentration Theory:

This theory was advocated by the physiocratic school of thought in France during the middle of the 18^th century. Physiocrats believed that there is an inherent tendency for all taxes to be concentrated on objects or classes which enjoy a surplus. Physiocrats believed that agriculture is the only productive sector.

According to the human labour applied in land, is able to generate a surplus and this surplus is called the net product. In industry, no surplus is generated. Trade and commerce were also considered as sterile by the physiocrats.

Nature has given land a blessing in the form of fertility. Hence, labour when applied to land is able to generate a surplus in the form of net product. This net product is appropriated by the landlords. Hence, physiocrats believed that in an economy, those could bear the taxes, which are appropriating a surplus.

Hence on whatever class the tax imposed, the payment would ultimately be made by the landed proprietors. All other classes and occupations are sterile. They did not yield any surplus, so that they cannot bear the burden of taxation.

If a tax was levied on these sterile classes, it will be shifted and re-shifted and ultimately fell on the landlords, who ex­tracts a surplus. Only a tax imposed on landlords can’t be shifted further because tax fall upon surplus income and it is paid out of it.

According to the physiocrats the shifting process involves fric­tion and waste. Hence, it is better to impose all taxes on land di­rectly or rather on the net product of land lord, than indirectly through other source. Hence, the physiocrats advocated that the govern­ment should concentrate on a single tax on economic rent earned by landlord. They also stood in favour of abolishing the diversified tax structure.

This theory with some modification was accepted by the classi­cal economists Adam Smith and David Ricardo. According to them taxes could rest only on net income or rent. Wages and profits were for the most part cost of production. Since, labour and business obtained little net income; most taxes imposed on them had to be shifted through an increase in prices and wages.

Tax Shifting # 2. The Diffusion Theory:

The diffusion theory was developed by the French writer like Canard and Mansfield. Diffusion theory is developed, contrary to the con­centration theory.

This theory states that taxes equate and diffuse themselves. This theory holds that government may impose such taxes as are most easily assessed and collected and will cause the least obstruction to national wealth.

It favours indirect taxation, trusting to the laws of trade to distribute the burden of taxation over the whole population. The diffu­sion theory of taxation is based on the assumption of perfect competi­tion and complete mobility of all economic agents.

According to this theory, the individuals from whom the tax is collected will not ultimately bear the entire burden of taxation. The burden will be shifted on to other classes and finally it will be diffused all over the society, untraceable.

In the words of Mansfield ‘a tax is like a stone falling into a lake and making a circle, till one circle produces and gives motion to another and the whole circumference is agitated from the center.

When a tax is imposed, it will be shifted and re-shifted; in such a manner that no one can escape from its incidence. When a com­modity is subject to taxation, the process of exchange shift the tax burden, extensively. This process of diffusion leads to equilibrium when the tax burden is equally distributed among all taxpayers. In this context, Canard made a beautiful narration of diffusion theory.

He states ‘the imposition of tax is just like extracting of blood from one of veins of a human being, although it is taken from a single vein, the loss in spread all over the body, and the body remains in equilib­rium’. However, Prof. Dalton disagreed with this theory. He believes that such an approach only tries to run away from the basic problem of ascertaining the incidence of tax. Walker also criticized this theory.

According to walker, this theory is based upon the assumption of perfect competition, which is a myth. The diffusion theory of incidence is shallow and misleading. It is shallow because it avoids the real difficulties in tracing out the incidence of a tax.

It simply states that the incidence in non-traceable. It is misleading because it as­sumes a state of perfect mobility of factors and the unrealistic as­sumption of perfect competition. Rather diffusion theory is a confes­sion of ignorance on the part of the advocates in tracing the path followed by particular taxes.

Tax Shifting # 3. Demand and Supply Theory of Incidence:

The extent, to which the monetary burden of a tax is shifted, either forward or backward, may be affected by the nature of the market structure within which the seller or buyer functions.

The possibility of shifting of tax depends to a large extent on the elasticity of demand and supply of the object of taxation. The demand and supply theory of incidence is considered as the most important solution to the problem of shifting of tax burden. Invariably, this theory is based upon the neo-classical theory of value and price, as stated by Prof. Alfred Marshall.

Prof. Seligman and Prof. Edge-worth applied this neo-classical theory of value and price in tax shifting under different demand and supply conditions.

This theory also asserts that tax incidence can be shifted only through a sale or purchase transaction. That is only through price revision. Price revision in turn is determined by the relative value of demand and supply.

Hence to summarizes, the sharing of the inci­dence between the buyer and seller will be determined by the de­mand and supply elasticity’s. The seller always tries to shift the tax burden upon the shoulders of consumers.

At the same-time the buyer may resist the shifting of the tax burden. Hence, the degree and character of shifting therefore depend upon the respective bargaining power of both seller and buyer.

Nature of Demand and Supply and Shifting of Tax:

As stated earlier, shifting of a tax depends to a great extent on the elasticity of demand and supply of the object of taxation.

Generally speaking, the greater the elasticity of demand of an article, the lesser is the chance of its being shifted to the consumer. Likewise, greater the elasticity of supply, the greater is the chance to shift the burden on to consumers when supply is elastic the bargaining power of the seller is greater.

He can increase or decrease supply according to circumstances. By withholding supply he can keep up the price and vice-versa.

Similarly, the bargaining power of the buyer is greater, when demand is elastic. The buyer is in a position to restrict demand or increase demand without much difficulty.

If the buyer feels that the price of an article is too high, he can reduce demand or postpone demand and force the seller to accept a reduced price.

Hence this theory of incidence can be explained under five extreme situation of elasticity of demand and supply:

(a) If the demand of a product is perfectly elastic, the consumer will demand the same quantity at any price. In this situation, the consumer will bear the entire money burden of the tax.

(b) If the taxed commodities demand is perfectly elastic, the entire incidence will be borne by the producer or seller.

(c) If the taxed commodities supply is perfectly inelastic, the entire incidence will fall upon the seller.

(d) On the other hand if the supply is perfectly elastic, the inci­dence will be on the buyer or consumer.

(e) A tax on an article which is jointly produced or jointly demanded with other articles can be shifted in part to the producer or con­sumer of the other commodity that enters in the joint relations. Let us take an illustration.

Wine and bottles are jointly demanded. If a tax is levied on wine and the wine producer cannot shift it to the consumer, he may try to obtain the bottles at lower prices and thus cause the burden of the tax to be shared by the maker of the bottle also.

Tax Shifting # 4. Fiscal Incidence and Its Measurement – Musgrave’s Approach:

Prof. Richard. A. Musgrave popularized a new concept of incidence. He point out that incidence takes into account the distributional con­sequence of budgetary policy change.

Prof. Musgrave defined the term incidence as the resulting change in the distribution of income available for private use, which arises as a result of changes in bud­get policy. That is changes in policy of taxation and public expendi­ture.

He pointed out that whenever budget policy is changed, it may result into three important effects: 

Firstly, it may affect the distribu­tion income between different sections of communities.

Secondly, it may lead to changes in the transfer of resources from private to public use and thirdly it may lead to changes in output According to Musgrave, the term incidence is used to denote the first type of effect.

To be more specific, resource transfer may occur without taxes and taxes may be imposed without resource transfer. How­ever, the resulting changes in the distribution of income have been referred as incidence.

Resource transfer implies that when a tax is imposed on the people, resources are transferred to the public sector from private use. Output effect imply that, imposition of a tax may lead to a change in factor input and hence in total output. For example, let us assume that a progressive income tax is imposed.

This may induce the workers to work less or work more leading to a change in the rate of savings and investments and thereby in rate of output growth. Likewise, change in budgetary policy may affect the distribution of income between different sections of the community.

All these ef­fects interact. Thus the distributional effect of a particular budget measure depends on their effects on capacity output and employ­ment just as the latter depend on concurrent changes in distribution. However, in the analysis of incidence Musgrave takes into consider­ation the distributional effect of tax and expenditure policies of the budget.

A. Statutory and Economic Incidence:

It is a fact that taxes are mandatory imposition and not a voluntary purchase payment. Taxes always impose burden, which the tax payers try to avoid or pass on to others shoulders.

When a tax is imposed, it involves a legal liability for payment, which may rest upon individual households as owner of the firm, employees or as consumers of their product. This legal liability for payment of tax is called statutory incidence. This involves two considerations.

Firstly, in the end, entire tax burden must be borne by individuals. Though taxes may be collected from business firms their ultimate burden must be traced to individual households as owners of firms, as em­ployees or as consumers of their product.

Secondly, the final burden distribution may differ from that of statutory liabilities, whether the tax is imposed on individuals or firms.

Due to the imposition of a tax, individuals as well as firms may adjust their sales and purchase, thus affecting the position of oth­ers. The person on whom statutory liability for payments rest may try to pass on the burden to others by changing the terms under which they are willing to trade.

Hence, whenever a tax is imposed a chain of adjustments will take place in the sphere of transactions. For example, an automobile excise duty levied on the seller may cause them to raise their prices hoping to pass the burden of tax to the buyers, who in turn will attempt to avoid it by substituting other purchases.

Imposition of an income tax may lead to reduced hours of work, thereby driving up the gross wage rate and burdening the consumers. In each case taxpayer’s ability to make such adjustments will depend on the willingness of the other transactor to go along. If the seller raises the price, the buyer will fight back by pur­chasing less.

Hence the outcome will depend on the response of the two parties. In essence, the resulting chain of adjustments may lead to a final distribution of burden, which Musgrave calls as economic incidence which differs greatly from statutory incidence.

B. Types of Tax Incidence:

Prof. Musgrave points out six concepts of incidence depending upon the types of budget policy considered. It is assumed that the budget changes occur with a classical system, where full employment is maintained automatically.

In such a situation, whenever a budgetary policy is changed, the distributional changes in income available for private use can be explained in the following way:

(a) Specific Tax Incidence:

One way to examine the concept of incidence is considering the distributional effect of imposing a particular tax, while holding public expenditure constant. That is changes in the distribution of income resulting from changes in particular tax function (say for example, personal income tax), while keeping public expenditure constant in real terms is called specific tax incidence.

Musgrave also called it as “Absolute Incidence”. Let us analyses the same by taking an ex­ample. Suppose, income tax is reduced without thereby a corre­sponding change in expenditure or an offsetting change in other taxes.

As a result income tax yield falls in both real and money terms. Private expenditure on the other hand increases due to increased income on the part of the individuals. This results in rise in price and cost and consequent increase in public expenditure in money terms to maintain real purchase.

In response to rise in income, tax yield will rise. But the initial losses are not fully recouped. The govern­ment is therefore forced to increase deficit spending to maintain the level of expenditure.

Then an inflationary process sets in motion. On the other hand when income tax rates are increased, there is a decrease in private expenditure due to reduction in income in the hands of the people.

This may generate a deflationary situation. Both inflationary and deflationary situation influence the distribution of income and wealth. The specific tax incidence thus produces two types of incidence. One is the incidence due to a change in a particular tax and the second is the incidence due to inflation or deflation.

(b) Differential Tax Incidence:

This refers to the distributional effect that result when one tax is substituted for another, keeping expenditure constant, and assum­ing that the money income of the two taxes is the same.

When one tax is substituted for another and revenue yield remain unchanged, it implies that the amount of public expenditure will remain the same. The substitution of equal yield taxes thus defined will be a balanced budget operation.

Let us take an illustration. Assuming that the government re­places Rs. 50/- millions of income tax revenue with a cigarette excise yielding the same amount of revenue. Fundamentally, this tax policy change involves no resource transfer to public use and imposes no net burden on the private sector.

It merely involves a redistribution of tax burden among households. Households, whose income tax li­ability is reduced, will gain. On the other hand, others with high cigarette purchases will lose. If we go beyond, tobacco growers and cigarette workers will lose. Whereas others producing the output purchased by the former income taxpayers stand to gain.

Hence, the resulting total change in the state of distribution is referred to as differential tax incidence. It measures the difference in the distribu­tional effects of financing a given expenditure by one tax or the other.

(c) Specific Expenditure Incidence:

Here is a situation when public expenditure changes whereas the tax rate structure and assessment formula remain constant. Under such a situation, the effect of change in public expenditure upon distribution is called specific expenditure incidence.

Increased pub­lic expenditure result in increased resource transfer to public use, as a result of increase in income of the people, in spite of constant tax functions. But the gain in yield will fall short of what is needed by the government. This will result in an inflationary process.

On the other hand, a decrease in expenditure will reduce the income of the people, and generate a deflationary situation by reducing aggregate demand for goods and services. In this way, changes in expenditure affect the distribution process in two ways – changes due to public expenditure and changes due to inflation and deflation which may arise due to changes in public expenditure policy.

(d) Differential Expenditure Incidence:

Under this concept, we hold the tax function constant and consider the changes in expenditure on different items under a balanced bud­get to avoid the impact of inflation and deflation.

The resulting changes in the distribution of income disposable for private use are referred to as differential expenditure incidence. Under a balanced budget policy, an increase in public expenditure in some direction is offseted by a decrease in expenditure in some other direction.

Such a differential expenditure, changes the relative factor and product prices. As a result it effects the distribution of income available for private use.

However, Musgrave admits that the concept of specific expenditure incidence and differential expenditure incidence is not much useful and significant as the concept of differential tax incidence, to analyses the problem of incidence of taxation and transfer of resources.

(e) Balanced Budget Incidence:

It is a situation in which changes in household income position is analyzed by taking the combined effect of tax and expenditure changes. As a result of this, income available to particular house­hold for private use will be affected not only by tax but also by expen­diture measures. For example, in the case of transfer payments private incomes are added to just as they are reduced by taxes.

In the case of provision for public services, the necessary purchase (either the service of civil servants or products) effect the distribution of private income through their effect on earnings. Thus the expendi­ture side of the budget has its effect on private incomes as taxes do have. Since the taxes and expenditure effects occur simultaneously, they cannot be separated in this case.