Diffusion Theory of Taxation:

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.

Assumptions:

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 it.

Criticism:

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 Commodities:

In considering incidence of a tax on commodities, we must fake into account following factors:

(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 on seller.

(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.

(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 increase.

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.