Theory of Taxation:
Definition and Explanation:
According to diffusion theory
of taxation, under
perfect competition, when a tax is levied, it
gets automatically equitably diffused or absorbed throughout the community.
Advocates of this theory, describe that:
"When a tax is imposed on a commodity by
state, it passes on to consumers automatically. Every individual bears burden of
tax according to his ability to bear it".
For instance, a specific tax is
imposed on say, cloth. Manufacturer raises prices of commodity by the amount of
tax. Consumers buy commodity according to their capacity and thus share burden
of tax. In the words of Mansfield:
"It is true that a tax laid on any
place is like a pebble falling into a lake and making circles till one circle
produces and gives motion to another".
This quotation has been given to
explain to readers that just as a pebble gets diffused in a lake, similarly a
tax imposed on a commodity is also absorbed and its burden is felt equally among
various sections of community.
Advocates of this theory assume
perfect competition in the market but in world of reality, it is imperfect
competition which prevails.
If tax gets automatically diffused through the community, then most of
worries of finance minister will be over. He will simply impose tax and collect
money from people without worrying about final resting place of a tax. In actual
practice we find that taxes do not get distributed equally. Some taxes remain
where they are imposed first and some are partly or wholly shifted on to me
consumers. Let us consider now some important taxes and see who ultimately pays
Diffusion theory of taxation has never gained any importance in the world of
reality. It has never been seen that a tax gets automatically equitably
distributed among people. It is true that in some taxes, diffusion or absorption
does take place but that too is not throughout the community.
Accordingly, the reason for rejecting theory of taxation is that there are
few taxes like income tax, inheritance tax, toll tax in which there is no
absorption at all. How can this theory state that tax burden is automatically
spread throughout the community?
Incidence of a Tax on
incidence of a tax on commodities, we must fake into account
(i) Elasticity of demand and supply: If the demand for a commodity is inelastic, then incidence of tax will be on purchasers. It is because
seller knows that if price is raised by full amount of tax, purchasers will not
curtail their demands. So he shifts the tax entirely on to the consumers. If
demand for a commodity is perfectly elastic, then incidence of tax is on
sellers because seller is aware of fact that if price is raised even by a
slight amount, purchasers will drop consumption.
Similarly, when supply of a commodity is perfectly elastic, incidence of tax
falls on to the consumers. This is because of fact that seller is in a position
to curtail production and when seller finds that he is not getting profit from
taxed commodity, he stops production and thus dictates terms. In case of perfect
inelastic supply, burden of tax finally rests on seller because he is not in a
position to raise price of commodity by reducing supply of it.
(ii) Availability of substitutes: If a taxed commodity has a number of
untaxed substitutes, then incidence of tax will be on seller. For example, if
government imposes tax on tea and coco remains unaffected from tax, then seller
of tea will not be able to raise its price because he knows that if he raises
price of tea he will lose customers, so he bears the tax himself. If substitutes
are not perfect, then seller can shift the tax on to the consumers.
(iii) Degree of competition: If commodities on which tax is levied are facing
stiff competition in market and tax is very small, then it may not be passed on
to purchaser due to fear of losing market. Incidence of tax in that case will be
(iv) Laws of return: If a commodity is produced under conditions of
diminishing returns, then prices may not rise by an equal amount of tax but by an
amount less than tax. Under conditions of increasing returns, it may rise by
more than the amount of tax. Under conditions of constant return, price rises by
full amount of tax.
(v) Incidence of tax on income: Economists are of opinion that incidence of
tax on income cannot ordinarily be shifted in form of addition to prices. It is
generally paid by person on whom it is levied. Businessmen, however, differ with
this view. They are of the view that burden of income tax can be shifted on to
the consumers in shape of higher prices.
When a trader endeavors to ascertain
his costs with a view to fix prices, he often takes into account the amount of
income tax he will have to pay.
If market conditions permit, he fixes
price at such a level as would yield to him maximum net income that he desires
to obtain. Economists here point out that businessmen cannot raise price of
commodity by full amount of tax because they are faced with stiff local and
foreign competition for their products. If they shift the burden of tax on to
purchasers, other producers will undersell and capture the whole of market.
(vi) Incidence of tax on monopoly: If a tax is levied on profits of a
monopolist, he will not be able to pass tax on to purchasers of his products. It
is due to fact that he has already fixed price which yield him maximum net
profit. If he raises price now, demand far commodity will curtail and so his
profit is reduced.
(vii) Incidence of tax on buildings: In case of buildings, there are two
main parties involved, owner of house or shop and occupier. When a tax is levied
on houses, owner tries to shift tax forward to occupier. Whether he will be able
to shift tax or not depends upon elasticity of demand for houses in that
locality. If demand for houses 'is inelastic, then tax in the first stage will
be shifted backward to occupier.
In long period, however, position
will be different. When owners of houses bear burden of tax, persons who are
desirous to construct houses will be discouraged and thus will not construct
houses. After sometimes, with increase in population, demand for houses will
Owners of houses will then be in a
position to shift burden of tax on to occupiers. If a house is given on a long
term lease, incidence of tax will be on owner. In case of a tax on shops, owner
will shift it forward to occupier, if he is not faced with stiff competition, he
will try to shift it on to consumers by raising price of commodities.
(viii) Tax on imports and exports: Tax on imports is shifted forward to
home consumers. But if demand for commodity is highly elastic and its supply is
inelastic, then tax can be shifted backward to foreign producer.
As regards tax on exports, incidence is on exporters. It is not possible
ordinarily for an exporter to influence world price. If he raises price of his
commodities by full amount of tax, his goods will not be sold in market. In
order to sell goods, he bears incidence of tax himself.
If, however, he is a monopolist and demand for his commodity is inelastic,
then he can shift tax forward to consumers in other countries.