CHAPTER 8

SHIFTING AND INCIDENCE

One common misconception about taxation is that the person or firm upon whom the tax is originally or
initially imposed is the very person or entity that actually bears the tax burden. This is not necessarily so because a
taxed individual or entity cannot be compelled to adsorb the tax himself. Nothing can prevent this individual or form
from transferring the burden of taxation to somebody else. The tax burden can therefore be transferred to somebody
else, in whe in a part, the conditions under which such transfers may be effected depending upon given circumstances.
This is especially so in the Philippines where the bulk of the country’s taxes is of the indirect type.

DEFINITION AND CONCEPT

The theory of shifting and incidence is a field in public finance that deals with the distribution of tax burden. In
the other words, it deals with how much each taxpayers or group of taxpayers contributes to the government, given the
tax system of the economy. The analysis of shifting and incidence can be untaken through both the partial and general-
equilibrium approaches. The former deals with the behavior of a specific variable on the assumption that all other
things are constant while the latter considers all changes that take place in the economic system due to the imposition
and collection of a given tax. The general-equilibrium approach is the more complete analysis but it involves complex
materials that are beyond the scope of this capter. We are going to utilize here the partial-equilibrium approach which
despite its restrictive assumptions, provides helpful generalizations.
The levying of a tax on something or somebody brings about a burden to the taxpayer concerned. The burden
of the tax defined as the amount of the tax involved. The subject of the tax is the individual who must pay the tax (also
termed as the statutory taxpayer). He is the taxpayer insofar as the tax law is concerned let us take the example of a
27.5 Centavos tax per litter of volume capacity imposed on beer, larger beer, ale, porter and the like as provided for in
our National Internal Revenue Code. The subject of this tax is of this tax is the domestic manufacturer of beer; if the
beer bought to abroad, the importer. The burden of the tax id the tax rate of 27.5 centavos per litter of volume capacity.
However, the manufacturer importer need to carry the burden if he can pass on the tax to his customers in terms of a
higher price. The process of passing on, or transferring part or all of, the tax burden from the subject of the tax to
another individual is called shifting. Hence, while the tax is initially paid in full by the manufacturer or importer of
beer, someone else may eventually shoulder part or all of the tax burden as a result of the process of shifting.
The incidence of taxation refers to the final resting or setting down of the tax burden. In our examples, the
incidence of the 25.7 centavos tax on beer and 40 percent sales tax on television sets on the individual or group of
individuals who cannot shift it further to somebody else.
A given tax may be shifted forward or backward, or may be absorbed by the statutory taxpayer. If the tax is
absorbed by the statutory taxpayer, shifting has not occurred and the incidence is on the subject of the tax. Forward
shifting takes place when the price of the taxed commodity is increased. If the price of beer rises because of the 27.5
centavos tax, then forward shifting has occurred. On the other hand, when the price paid for the factors or production
involved in the manufacture of the taxed commodity has decreased, backward shifting has taken place. If
manufacturers of beer have been able to decrease the salary of their employees or the price at which they bought their
raw materials has been reduced because of the tax, backward shifting has been effected.

FACTORS THAT INFLUENCE SHIFTING AND INCIDENCE

The direction and magnitude of shifting are influenced by several variables. Among the more important
considerations are:
1. The nature of the tax
2. Demand and supply conditions
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 3. External factor
Nature of the tax. Theoretically, taxes on income and wealth are not shifted in the short-run period. Let us
consider the case of individual and corporate income taxes. Wages or salary income derived from the sale personal
services in determined through the market (or total) supply and demand for such personal services. This means that
salary is given or fixed for any person. As such, an individual has no choice but to accept the prevailing wage rate
regardless of whether or not his take-home pay is sizeably reduced to the extent of the income tax. A tax on wage or
salary income is therefore not shifted and is borne by the subject of the tax. However, the formation of a strong labor
union and up possibilities of employees shifting to management a part of their income tax liabilities.
Corporate income tax is similarly not shifted in the short run. The graph below shows the relevant
considerations for a hypothetical firm operating in a non-purely competitive market situation.

Before income tax is collected, the firm obtains maximum (or the highest) profits by producing 1,000,000 units
at a selling price of .40 each. It can be seen form the graph that the firm device total profits amounting to 200,000. Now
let us assume that the prevailing tax is a flat 50 percent profit (or net income). The firm therefore has to pay 100,000 as
income tax and is left with 100,000 as profit net of tax. Should the firm produce more (and decreases its price) or
produce less (and increase it price) in order to pass on to its buyers a part or all of the tax it has to pay? The answer is
no. the firm would obtain the highest profit possible at an output of 1,000,000 units, regardless of the amount of
income tax payable.
The tax imposed on production and sale, unlike those on income and wealth, are generally shift able. Such
taxes are cost to the firm and have to be considered in the determination of its optimum price and production.
Production and sales taxes constitute addition to either fix or variable costs. Let us again consider the hypothetical firm
in figure 1. Assume that this firm is engaged in brewing and must therefore pay an annual fixed tax of 5,000 a provided
by the Tax Code. Such a tax is an addition to fixed costs, that is, the tax does not vary with the production of the firm.
The tax will raise average fixed cost (AFC) and average cost (AC) at all levels of output, but marginal cost will remain
unchanged. Figure 2 shows that the goal of maximum profits still dictates the production of 1,000,000 unit because it is
the output where marginal cost is equal to marginal revenue. As such, the fixed tax is shouldered by the firm. Shifting
is not possible.

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 Consider now, say, a 25 centavos tax per liter on its production of beer. This tax is an addition to variable costs
that is, each unit of production of subject to the 25 centavos tax. The higher the production of the firm, the greater the
total amount of taxes it has to pay. Figures 3 illustrates the process of shifting.

Before the 25 centavos tax per liter, the firm produce 1,000,000 units and sales at 0.40 per unit. With the tax,
the cost of producing a liter of beer must necessary increase. This is seen by the movement of the average cost curve
from AC to AC1 and that of the marginal cost curve form MC to MC 1. (AC and MC are indicate in bold continuous
lines). With the movement of MC, a new equilibrium position is reached. Optimum production has decreased as price
has risen. Hence, forward shifting to the customer has been effected through an increase in price of beer.
Price Elasticity of Demand and Supply. – Price elasticity of demand is defined as the ratio of the percentage
change in quantity demanded to the percentage change in price. In like manner price elasticity of supply is the ratio of
the percentage change in quantity supplied to the percentage change in price.
A segment of the demand curve for a commodity is said to be elastic when a percentage change in price is
accompanied by a more than proportionate percentage change in quantity demanded. When a percentage change in
price in accompanied by a proportionate percentage change in quantity demanded that segment of demand is said to
have
unitary elasticity. A segment of demand is inelastic is a percentage change in price is accompanied by a less
than proportionate percentage change in quantity demanded. Commodities for which there are good substitutes usually
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have elastic demand. Necessities such as food and clothing, in the relevant price ranges, generally have inelastic
demand.
In general, the more inelastic the demand for the taxed commodity, the greater is the possibility of forward
shifting. This arises because the increase in price would not substantially reduce the purchases of the tax commodity.
Similarly, the more inelastic the supply factors that go into the production of the taxed commodity, the greater is the
possibility that backward shifting will occur. On the other hand, an elastic demand for the demand for the taxed
commodity occasions less forward shifting and an elastic supply of the factors of production occasion less backward
shifting. Seller faced with elastic demand for their product do not have much roof for shifting because an increase in
price world would be accompanied by a more than proportionate decrease in units sold.
External Factors. The extent and direction of shifting are heavily influenced by external or institutional
factors. The existence of customary prices inhibits to some degree the occurrence of forward shifting. When the price
of a commodity has been customarily related to a small “round” prices, or where the seller has stressed price in his
sales campaign, the seller will have to think twice before shifting forward a newly-imposed tax. The goodwill of his
commodity might be lost if he increases his price. State regulations impose a more serve restriction on forward shifting.
Take the case of utility industries, such as transportation, water, and electricity. The demand for commodities or
service produced by this industries may will be approaching perfect inelasticity, hence, full forward shifting is made
possible. In actual situation the possibility of shifting a tax, imposed on the operators or franchise holders to the
consumer, appear to be very small because of government intervention. With respect to backward shifting, it is
impeded by institutional factors, such as minimum wage regulations and labor unions which possess strong bargaining
power with management.
External influences upon tax shifting considerably vary depending on prevailing circumstances. Consider the
role of puvlic policy and the coverage of the tax. If the tax on gasoline, for instance, accrues to a highway special fund
which is expended only for the construction and maintenance of an improved system roads and bridges, the resistance
of motorists to forward shifting is weakened. The coverage of the tax bears a direct relationship to forward shifting. If
the consumer cannot avail of the taxed commodity in a nearby area where such commodity is untaxed, or is the tax is
generally applied as to include close substitutes, the consumer will likely bear the major portion of the tax burden.

SHIFTING OF CORPORATE INCOME TAX

What happens when the government levies a tax on corporations? Are these taxes borne by the corporation as
part of its operational costs, shifted to stockholders in the form of reduced dividends, or shifted to the consumers in the
form of increased prices?
Several factors would influence the decision of the corporation regarding the tax. In the first place, it would
depend upon the degree of demand elasticity of the product being sold by the firm. If the product has a relatively
inelastic demand (necessities), chances are that the tax will be shifted to the consumers In the form of increased prices
rather than borne by the corporation as increased production cost or transferred to the stock holders as a cut in divided
earnings. Secondly, it would also depend upon whether the firm is operating under condition of pure competitive
(perfect competition) or non-perfectly competitive conditions. If the firm approximates pure competition. The tax may
be borne by the corporation or shifted to the stockholders. However, if the firm operates under conditions of non-
perfect competition, the tax, or at least a substantial part of it, will be shifted to the consumers in the form of increased
prices. Among others, this would mean a reduction in real income of those buyers or consumers who would be
adversely affected by the tax, and for this reason the corporate tax could be treated like any ordinary sales tax.
Actually there are two schools of thought regarding the treatment of corporate taxes. The first emphasizes the
behavior of the rate of return investment capital in the corporate sector, while the second stresses the changes in the
relative shares of income going to capital and labor.
The first or earlier rate-of-return “school” is based on empirical studies conducted by E. M. Lerner and E. S.
Hendriksen on American corporation form 1927 to 1962. The studies showed that “a relatively constant rate of after-
tax return (was evident) in the period 1927-1962, despite a sharp increase in corporate income tax. The before-tax
return roughly doubled over the period. The study also showed that the gross rate of return did not adjust
immediately to the tax changes in either direction”

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 The second school, attributed to Professor M. Kryzaniak and R. Musgrave, sought to avoid this limitation. The
study emphasized the use of a profit behavior model and multiple regression techniques, and sought to isolate the
effects of the corporates tax from other exogenous factors affecting the rate of return. Essentially a short-run analysis,
the study sought to determine the effects of the tax year by year, comparing the actual behavior with the behavior that
the model suggests without the tax.
Like the Lerner-Hendriksen formula, the Kryzaniak-Musgrave model is severely criticized. In the first place, it
is argued that the study was inadequate insofar as insulating the tax influences from those non-tax variables is
concerned. Secondly, it was claimed that it is impossible to shift the corporate tax fully to the consumers, inasmuch as
the latter may, depending upon the amount. Of the tax find substitutes for the products or totally forego buying the
product if no close substitute are available. This would apply to non-essential and luxuries. One study in the United
States even showed that “the tax is not shifted at all but rest entirely upon the capital owners”.
In conclusion it is very difficult to say with any degree of certainty or finality whether a corporate tax is shifted
to consumer absorbed by the corporation, or transferred to the stockholders. So many imponderables enter the picture.
The most important of these are the degree of demand elasticity of the product, the availability of substitutes, the
competitive and non-competitive position of the firm etc, in fact, non-economic factors could give included. Among
these are the rate of return to investment (profit expectation), government policies on business general, etc. between
these two sets of limitations, the second is of course more difficult or unpredictable than the first.

TAX BURDEN BY INCOME CLASS IN THE PHILIPPINES

In 1961, the Joint Legislative-Executive Tax Commission undertook a survey to determine the distribution of
the tax burden among household of different income classes. The survey gathered data on family income and
expenditures on selected commodities. Both income and expenditures items were for 1960. Utilizing the 1960 tax
collection obtained from the Bureau of Internal Revenue, the Bureau of Customs, and other government offices a series
for allocating taxes to the various income classes was devised.
This tax burden study indicates how much each income group contributes to the support of government. we
have stated above that taxes although imposed on, say, manufacturers, are paid by somebody else in terms of higher
prices for the taxed commodity. The importance of this survey relates to the fact that an effective tax reform requires
the determination of who actually shoulders the burden of existing taxes.
The results of the study are as follow:
A. Money Burden
1. Family households bear an average tax burden of 297. Of the average tax burden, 215 or 72.5 percent
arises on account of taxes on production and sale, and 82 or 27.5 percent is due to taxes on income and
property.
2. Average tax burden rises as income increase – 154 on the low-income group, 608 on the middle-income
group, 6,598 on high-income and property.
3. Average tax burden for production and sales taxes – 133 on the low-income group, 495 on the middle-
income group, 2,409 on the high-income group.
4. Average tax burden for income and property taxes – 21 on the low-income group, 113 on the middle-
income group, 4,191 on the high-income group.

B. Effective Tax Burden

1. For every peso income of family households about 0.20 go to taxes: 0.15 in the form of production and
sales taxes and 0.05 in income and property taxes:
2. The effective tax rate structure is generally regressive – the low-income group has an over-all effective rate
of 19.5 percent, the middle-income group, 17.7 percent, and the high-income group, 33.5 percent.
3. The preponderance of taxes on production and sale accounts for the regressively of the whole tax system –
the effective tax rate structure of production and sales taxes ranges from 21.2 percent for the lowest
income class to 12.2 percent for the highest income class; that of income class and property taxes from 1.8
percent for the lowest income class to 21.3 percent for the highest income class.

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 C. Income Distribution
1. Total income of family households amounted to 7,004 million; 5,443 million or 77.7 percent in cash and
1,561 million or 22.3 percent in kind.
2. Average income of family households is 1,474 – of the low-income group, 836; middle-income group,
3,551; high-income group, 19,697.
3. About 83.1 percent of family households had income of less than 2,000; about 1.1 percent with income of
10,000 and over.
4. Almost two-thirds of total household gross income are in the hands of only 10 percent of total family
households.

D. Expenditure Patterns

1. Total expenditure of family households amounted to 8,110 million, or an average expenditures of 1,709.
2. For every peso spent about 0.50 go to food, 0.22 to housing, 0.11 to miscellaneous expenses, 0.09 to
clothing and footwear, 0.06 to alcoholic beverage and tobacco products, and 0.03 to luxury goods and
recreation.
3. Expenditures for food and for alcoholic beverages and tobacco products show a declining pattern from the
lowest income class to the highest income class.
4. Ratio of expenditures for clothing and footwear to total expenditures is about the safe for all income
classes.
5. Generally, the higher the income class, the higher the amount spent on housing, luxury goods and
recreation and miscellaneous expense.
Significance of the Tax Burden Study. – Three important conclusion, among other, are pinpointed by this tax
burden study. Firstly, there is need to re-examine the ratio of taxes on income and property to total tax collections. The
greater ratio of the former to the latter, the more the principles of equity and ability-to-pay are enhanced. It is to be
noted that in the Philippines the ratio of taxes on income and property to total tax collections (27.5 percent) is way
below that of more progressive economies. The ratio of income and property taxes to total tax collections in the United
States is 61.3 percent; Canada, 60.4 percent; Australia, 59.7 percent; Sweden, 51.9 percent; and Japan, 49.7 percent.
Some countries which are relatively in the same development stage as the Philippines have higher ratios, to wit:
Indonesia 42.3 percent; Mexico, 36.9 percent; and Burma, 30.9 percent.
Secondly, since only about 10 out of 57 taxes may be considered as major sources of revenue, a study on
revenue productivity of the remaining 47 taxes is in order. Collections from these low revenue producing taxes roughly
constitute a meagre 16.1 percent of total tax collections. It may be that the cost of collecting some of these taxes is
greater than their revenue yield.
Finally, the topic of taxable capacity is brought into focus information on the relationship between tax burden
and taxable capacity would facilitate the attainment of the goal of a just and equitable distribution of the tax burden.
Individuals or groups of individuals who are not presently carrying their due share of the cost of government deprive
the government of much-needed resources with which to finance its growing expenditures requirements
From an over-all standpoint, the primary importance of this study on the distribution by income class of the
burden of different taxes relates to the fact that it provides policy-makers a sound basis in setting tax rates that are
consonant with the equity and ability-to-pay requirements of a progressive tax system.

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 REFERENCES

Chapman, Brian (Genral Editor), Public Finance and Budgetary Policy. New York: Federick A. Praeger, Inc.
1963.
Dalton, Hugh, Principles of Public Finance, 4th ed., London : Routledge & Kegan Paul, 1954, Chapter 7 and 8.
Groves, Harold, Financing Government, 4th ed., New York: Holt and Company, 1954, Chapter 6.
Joint Legislative-Executive Tax Commission, A Study of Tax BurdenBy Income Class in the Philippines,
Manila Tax Commission, 1954, Chapter VI.
Prest, A. R., Public Finance in Underveloped Countries. Great Britian: Ebenezer Baylis and Sons, Ltd., 1962.
Roph, Earl A., and Break, George E., Public Finance. New York: The Ronald Press Co., 1961.
Slinger, Bernard A., and Sharp, Ansel M.m Public Finance. Homewood, III: The Dorsey Press, 1961.
Somers, Harold M., Public Finance and National Income. Philadelphia: The Blakiston Co., 1949.
Strayer, Paul A., Fiscal Policy and Politics. New York: Harper & Bros., 1958.
Taylor, P. E., The Economics of Public Finance, 3rd ed., New York: MacMillan, 1961.
Yoingco, A. Q., et al., Economic Analysis, 1966, ed., Manila: GIC Enterprise, 1966, Chapter 4.

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