Top 4 Theories of Tax Shifting

Tax Shifting # 1. Concentration Theory:

This theory was advocated by the physiocratic school of thought in France during the middle of
the 18th 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.

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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.

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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 ex-
ample. 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.