Worked example 2 — Total outlay, tax incidence and why the burden shifts

Two sentences from two different modules have to be put together, and putting them together is the whole of this example.

From Module 1: Government fixes higher tax rates on goods having inelastic demand and lower rates on goods having elastic demand.

From Module 3: an indirect tax is one levied on commodities and services, affecting the income of a person through their consumption expenditure, and here the burden can be shifted to some other person — customs duties, sales tax, service tax and excise duties are the examples given. A direct tax, by contrast, has to be paid by the person on whom it is levied and its burden cannot be shifted.

Put the two together and the question becomes precise. Shifting is not a legal fact but an economic one. The statute names a person who must pay; whether that person actually bears the tax depends on elasticity, and on nothing else. This example works that out.

Start with the vocabulary, because an answer that muddles these two words gets no marks.

• Impact — the person on whom the levy falls in law, who must account for the tax. Fixed by the statute.
• Incidence — the person whose real income is reduced when the dust settles. Fixed by the market.

Article 265 of the Constitution controls the first: no tax shall be levied or collected except by authority of law. Nothing in the Constitution or in any taxing statute controls the second. That gap is where the economics lives.

A seller faced with a new tax would like to add the whole of it to the price. Whether they can depends on what buyers do at the higher price, and what buyers do at the higher price is exactly what the elasticity coefficient measures.

• If demand is perfectly inelastic — even substantial changes in price leave demand unaffected, the coefficient being 0 — then the seller can add the whole tax and lose no sales. The buyer bears all of it.
• If demand is perfectly elastic — demand is infinite at the prevailing price, and the slightest rise in price makes quantity demanded fall to zero — then the seller can add nothing. The seller bears all of it.
• Every real good lies between these, and the share the buyer bears rises as demand becomes more inelastic.

Take the individual demand schedule again, and note the total outlay at each price:

| Price (Rs.) | Quantity | Total outlay (Rs.) | |---|---|---| | 1 | 5 | 5 | | 2 | 4 | 8 | | 3 | 3 | 9 | | 4 | 2 | 8 |

A tax that raises the price from Rs. 2 to Rs. 3. Quantity falls from 4 to 3 — a quarter of the sales go. Total outlay by buyers rises, from Rs. 8 to Rs. 9, so the buyers as a group are spending more even though they are buying less. That is the signature of an inelastic stretch, and it is why a tax imposed here yields revenue: the base does not collapse.

A tax that raises the price from Rs. 3 to Rs. 4. Quantity falls from 3 to 2 — a third of the sales go — and total outlay falls, from Rs. 9 to Rs. 8. On this elastic stretch the tax destroys more turnover than it captures.

That contrast, on four rows of a teaching schedule, is the entire case for taxing necessaries and not luxuries when revenue is the object — and the entire case against it when equity is the object.

The tax chapter records the classification by rate structure: proportional taxation keeps the rate constant irrespective of changes in the tax base; progressive taxation raises the rate as income rises; regressive taxation lowers the rate as the base increases; and digressive taxation is progressive up to a limit and then constant.

Here is the sting. An indirect tax at a flat rate is proportional on its face and regressive in effect, because a poorer household spends a larger share of its income on consumption. The goods with the most inelastic demand — necessaries such as salt, kerosene, matchboxes, textbooks, seasonal vegetables — are exactly the goods a poor household cannot stop buying. So the rule that maximises revenue is the rule that falls hardest on those least able to pay.

That is why essential goods are usually taxed at lower rates or exempted, and why every consumption-tax structure carries a schedule of rates rather than a single one. The economics tells you where the revenue is; the policy choice is how much of it to forgo.

The same example decides a second design question. A specific duty is based on specific characteristics or measures or qualities of goods, levied on physical attributes such as length, weight or volume, and is simple, easy to estimate and administer. An ad valorem duty is expressed as a percentage of the value of the commodity, and results in higher tax revenue with increases in the volume as well as the price of goods.

On our schedule, a specific duty of Re. 1 per unit and an ad valorem duty of 50 per cent both take the price from Rs. 2 to Rs. 3 — this year. Next year, if the price level rises, the specific duty still takes Re. 1 while the ad valorem duty takes half of whatever the price now is. The trade-off is administrability against buoyancy: a specific duty is easy to assess but its real value erodes with inflation, while an ad valorem duty keeps pace with prices but requires the value to be determined, which is where valuation disputes — a large part of customs and excise litigation — come from.

The identical reasoning governs a customs duty, and the WTO chapter supplies the frame. Under national treatment, imported and locally produced goods should be treated equally at least after the foreign goods have entered the market — but national treatment only applies once a product has entered the market, so charging customs duty on an import is not a violation of national treatment even if locally produced products are not charged an equivalent tax. A tariff is lawful; a discriminatory internal tax is not.

So the tariff is a lawful instrument whose economic effect is settled by elasticity in exactly the way worked above, while the internal tax is legally constrained however it might have been designed. Two levies, identical arithmetic, different law.

The balance of payments chapter records what India did with this logic after 1991. The Tax Reforms Committee's main strategy was to reduce the proportion of trade taxes in total tax revenue, increase the share of domestic consumption taxes by converting the excise into a value added tax, and enhance the contribution of direct taxes to total revenue. Customs peak rates fell from above 150 per cent in 1991-92 to 40 per cent in 1997-98, 30 in 2002-03, 25 in 2003-04 and 15 in 2005-06, and the number of major duty rates was cut from 22 in 1990-91 to 4 in 2003-04.

The reason is exactly the one this example has been building: a country that has decided to tax imports less must find its revenue somewhere else, and the somewhere else is a broad domestic consumption tax plus direct taxes. The Economic Survey records that the Goods and Services Tax has played a stabilising role by strengthening Government revenues, deepening formalisation, and reinforcing the Government's reform intent, with gross GST revenue during April to December 2025 at ₹17.4 lakh crore, a year-on-year growth of 6.7 per cent — and that its growth has broadly aligned with prevailing nominal GDP growth conditions, being influenced in part by lower inflation.

That last clause is this example in a single line. A broad ad valorem consumption tax grows with the money value of output, so its yield falls automatically when inflation falls, independently of any change in rates.

It gives no measured elasticity for any Indian commodity, and no estimate of how any Indian tax is actually shared between buyer and seller. The schedule is a teaching schedule; the split of the burden is derived from the definitions, not measured.

1. Impact is fixed by statute under Art. 265; incidence is fixed by elasticity.
2. Perfectly inelastic demand → buyer bears all; perfectly elastic → seller bears all; everything real is in between.
3. On the schedule, a tax over the inelastic stretch raises total outlay from Rs. 8 to Rs. 9; over the elastic stretch it cuts outlay from Rs. 9 to Rs. 8.
4. Hence: tax inelastic goods for revenue — and hence the regressivity objection, since necessaries are the inelastic goods.
5. Specific duty = easy to administer, erodes with inflation. Ad valorem = buoyant, breeds valuation disputes. India moved from trade taxes to a broad ad valorem domestic consumption tax after 1991.