Theories of Tax Incidence and Shifting:

1) Concentration Theory:
This theory was advocated by the physiocratic school of thought and the Classical Economists 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 them, human labour applied in land, is able to
generate a surplus and this surplus is called the net product. In industry, no such surplus is generated.
Trade and commerce were also considered as sterile by the physiocrats. The nature has given land as 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. Thus, physiocrats believed that
in an economy, only those could bear the taxes, which are appropriating a surplus. Therefore, on
whatever class the tax imposed, the payment would ultimately be made by the landed proprietors (or
landowners). All other classes and occupations are sterile and not fruitful. 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 fall on the landlords, who ex-tracts a surplus. Only a tax
imposed on landlords can’t be shifted further because tax falls upon surplus income and it is paid out
of it. According to the Classical Economists, in an economy only those who could bear the taxes, who
were appropriating a “surplus”. To them, the artisans and other classes (except peasants) were not
producers of surplus, since in such cases the value of the final output was only equal to the value of
the inputs. However, the story was different for agriculture. There the produces far exceeded the
inputs and it was this surplus, which was appropriated by the landlords as rent. Accordingly, the only
source from which tax revenue could finally come was the land rent. End Note: concentration theory
focuses on impact of tax and hence direct taxation.
2) The Diffusion Theory:
The diffusion theory was developed by the French writers 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, 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 assumes of perfect competition and complete mobility of all economic
agents or factors of production. According to this theory, the individuals from whom the tax is levied /
collected will not ultimately bear the entire burden of taxation. The burden will be shifted on to other
classes (and sectors) and finally it will be diffused all over the society, untraceable. In the words of
Mansfield “a tax is 16 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
and burden. When a commodity is subject to taxation, the process of exchange, shifts the tax burden
extensively. This process of diffusion leads to equilibrium when the tax burden is equally distributed
among all taxpayers in a society (or a nation). Some economists have maintained that because of the
constant interaction of sales and purchase transactions, eventually it becomes impossible to trace the
final incidence of any tax and that, in reality, all taxes get “diffused” in the economic system. Thus, it
follows from the above that, it hardly matters where the taxes are being imposed, in the first place,
since they shall anyhow get well diffused in due course of time. Criticism: Walker has criticized the
diffusion 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 and that 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.
End Note: diffusion theory focuses of shifting and incidence of tax and hence indirect taxation.
3) Demand and Supply Theory of Incidence:
This is the most acceptable approach in explaining the incidence of a tax. 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 neoclassical 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. A tax
can, therefore, be shifted only through a shift in the demand and/or supply curves and the sharing of
the incidence will be determined by the demand and supply elasticities. The general rule is that
irrespective of whether the statutory liability of a tax (impact of tax) rests upon the buyer or the seller,
the share of the tax borne by the seller will be larger if the elasticity of demand is larger; and the share
of the tax borne by the buyer will be larger if the elasticity of supply is larger. Hence to summarizes,
the sharing of the incidence between the buyer and seller will be determined by the demand and
supply elasticity’s (of the object / good being taxed). 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.
The degree and character of tax shifting therefore depends upon the respective bargaining power of
both seller and buyer. End Note: D&S theory focuses of elasticity and incidence of taxes and hence
indirect taxation.
General Theories of Taxation:
1) The Cost of Service Theory:
According to the cost of service theory, the cost incurred by the government in providing certain
services to the citizens must collectively be met by the people, who are the ultimate receivers of the
services. This theory believes that the tax is similar to a price. So, if a person does not utilize the
service of the state, he should not be charged any tax. In words of Buehler, “the taxes should be prices
or rate paid for the services rendered to each person by governments according to the cost incurred”.
Hence, the basis of taxation should be the cost of the different services rendered by the government to
the tax payers. This principle is full of many conceptual difficulties; firstly, we have the problem of
measuring the cost of state services and assigning them to the beneficiaries. Secondly, in many cases,
it is not possible to have a conceptual clarity of the cost measures. Thirdly, several state services,
which have externalities appear in the form of social benefits and social costs. Here, should the state
confine its attention to only the commercial costs as the private entrepreneurs do? Or should it take
into account the externalities also and estimate the net social cost in determining the tax liability?
Lastly, the state has to decide about the extent and nature of state services to be provided to the
citizens.
2) The Benefit Theory:
According to this theory, the burden of taxation should fall on the people according to the benefit
received by them from the state. In other words, the collective amount of taxes should not be more
than the aggregate benefit secured by the tax payers. Whatever services the government confers on the
people, they provide some benefits to them. So, the people should share the burden of taxation in
proportion to the benefits receive by them. According to J. S. Mill, the relationship between the tax
payer and the state runs in quid pro quo terms. It implies that tax should be imposed in proportion to
the benefit received by a person from the expenditure (cost) made by the government in rendering the
public goods and services. The main feature of benefit principle is that the relation between taxpayers
and government is one of exchange. The total tax bill for each taxpayer should equal the real benefits
that he receives from consumption of public services. The taxes should be distributed among
individual taxpayers on the basis of marginal benefit received by them, not total benefit. For Example:
Financing roads with gasoline taxes as a mechanism for relating benefits to taxes. Most user charges,
such as tolls for road and bridge use, fares for use of public transport, and admission fees for use of
recreational and cultural facilities, are based on the benefit principle. However, it is impossible to
identify the magnitude of the benefits received by different individuals. For Example: we all receive
some benefits from defence expenditures, but how are the relative benefits to be apportioned among
different individuals? For many such categories of expenditure assessment of benefits is essentially
impossible. Further, taxes on usage of public facility may discourage its use and thus lead to
distortionary (inefficient) allocation of resources. For Example: Indirect taxes are an example of the
benefit principle. If a consumer derives satisfaction (or benefits) by consuming / using a luxurious car,
he has to pay a higher tax in terms of an import duty.
The problem of double counting benefits: Public projects often lead to asset -value increases. For
example, the fact that consumers save time driving to work when the highway is improved could lead
to higher values for houses farther away from the city. When considering the value of this highway
improvement, some may count both the reduction in travel times and the increase in the value of
houses as a benefit. Because the rise in house values results from the reduction in travel time,
however, both should not be counted as benefits.
3) Ability to Pay Principle:
The ability to pay principle of taxation is just, equitable and the most accepted theory of taxation. This
theory proposes that those who possess income or wealth should contribute to the support of public
functions according to their relative ability to pay. In brief, the burden of tax should be according to
the ability (to pay) of the tax payers. Those who have means to pay should pay and those who have
not, need not pay. According to Adam Smith, “the subjects (citizens) of every state ought to
contribute towards the support of the government, as nearly as possible in proportion to their
respective abilities”. J. S. Mill was among the main supporters of this theory. The ability-to-pay
theory maintains that taxes should be distributed according to the capacity of taxpayers to pay them.
Citizens with greater ability to earn income, for example, should be taxed more heavily than those
with less capacity to earn. Using this approach, the problem of distributing tax shares is viewed as
independent of individual marginal benefits received from government activities and/or services. The
basic tenet of the ability-to-pay doctrine is that the burden of taxation should be shared by the
members of the society on the principles of justice and equity and that these principles necessitate that
the tax burden is apportioned according to their relative ability to pay. Points to remember here; i. The
doctrine of ability to pay is combined, in certain cases, with the objectives of maximum social
welfare. ii. There are several indices and variables for determining relative ability to pay of the tax
payer such as income, property and wealth and consumption expenditure. Musgrave speaks three
types of ability to pay approach. First view discusses the distribution of tax payments only. The
expenditure side of the budget is taken as given or determined not according to tax principles but by
some other principles. The State levies the tax in an equitable or just way. According to the second
view, sharing of tax burden is a matter of welfare economics, not of justice. Taxes should be levied in
a way that minimizes the total sacrifice and this is attained by equating the marginal sacrifices of all
taxpayers. The expenditure side of the budget is not still considered. The third party / view retains the
welfare approach to the determination of tax burden but the argument is extended to cover the
expenditure side as well. The aim of the budget, not only of taxation, is to maximize welfare. This
approach is developed by Pigou and Dalton.
Difference between the theories:
o While the cost of service approach to the distribution of tax burden implies that the government
should try to have a balanced budget, the ability to pay approach does not have any such direct
implications.
o The basic difference between the two approaches – the benefit principle and the ability to pay
principle, pertains to the nature of the public revenue-expenditure process. The relation between the
taxpayer and the government is seen in quid quo (or proportionate) terms in the benefit principle. In
the ability to pay principle, contribution of the taxpayers made towards public good is independent of
benefits accruing from such goods (rather depending on the ability to pay of the tax payer).
o Taxes are compulsory payments. There is no quid pro quo relationship (in ability to pay theory),
between taxpayers and government, there is no exchange relationship between the parties and hence
revenue-expenditure process is viewed as a planning problem, which cannot be solved by the
automatic working of the market.
o Benefit principle approach cannot solve the problem of distribution and stabilization, although it has
the merit of solving the problem of allocation that is division of country’s resources(and income) for
the production of private and public goods, according to individual preferences for both types of
goods.
o Ability to pay approach is superior in the respect because it can tackle the problem relating to all
three major fiscal functions of allocation, distribution and stabilization (in line with objectives of
fiscal policy). But this principle “does not tell us just how the tax burden is to be distributed”.