The relative burden, or incidence, of an indirect tax is determined by the price elasticity of demand (PED) of the consumer in response to a price rise. If the consumer is unresponsive, and PED is inelastic, the burden will fall mainly on the consumer. However, if the consumer is responsive to the price rise, and PED is elastic, the burden will fall mainly on the firm.
Tax burden on the consumer
When demand is inelastic the tax burden is mainly on the consumer.
Tax burden on producer
When demand is elastic, the tax burden is mainly on the producer.
Tax burden evenly split
In this case, the tax burden is split evenly between the consumer and producer.
Example – the incidence of a tax on cigarettes
If a government puts a £1 tax on each packet of cigarettes, the legal incidence is on the cigarette smoker. However, the local market may have many sellers, and be highly competitive. This means that a retailer, fearing they will lose sales, may decide to put up the price by only 50p, and pay the balance of 50p to the government themselves. In this case, the economic incidence is shared because both are worse off.
The smoker is worse off because of the price increase of 20p, and the seller is worse off because 10p must come out of their revenue to pay the government.