The Diffusion Theory of Incidence of Taxation

The theory

According to this theory, any tax is shifted automatically in the economic system ad infinitum such that every person in the economy bears the burden of the tax. In the end the amount of tax borne by an individual in the system is so small that it is practically burden- less. 

The theory is a fallacy. It is based on the false assumption that there are successive infinitive transactions. It assumes that a person who purchases any product on which tax has been imposed will use the product as an input in production. When he sells his finished products he transfers a small portion of the tax to each of the purchasers. Such purchasers use the product in production of other products and there process of transfer is repeated until the tax being transferred is so little that its burden cannot be felt by the person on whom it finally rests. This is far from the practical reality. Sometimes products on which tax has been imposed are bought directly by the final consumer from the person on whom the tax is initially imposed. A person might buy beer from a brewer for his own consumption. Such a person cannot pass the tax burden to anyone; he bears the whole of it.

Even where there are a series of transfers the final consumer may end up carrying the whole burden of the tax as originally imposed. Consider a brewer in Kenya on whose beer excise duty is imposed. The excise duty is imposed on the ex-factory price. The brewer factors the excise duty in the selling price. A bar operator who purchases the beer from the factory will temporarily bear the burden of the excise duty before transferring it to his customers. A customer who buys the beer from the bar is not in a position to transfer the tax to anyone. He therefore bears the whole burden of the excise duty.

At times products may be used to manufacture other products successively but the process is never infinitive. Even when we consider a case where there are several transfers the tax borne by the final consumer is not so little as to be burden-less. Consider a manufacturer who is using an item that is the product of six manufacturing processes since the original product was manufactured. At this point the tax being passed should be very little and he should pass an even lesser amount to his customers. Does such a manufacturer pass only a little tax to each consumer? The answer is no, why? 

The reason is, a product will require several inputs to produce it and since taxes are imposed on a wide range of products, all the tax components of each input will make the tax component of the product significant. For instance a manufacturer of VATable goods in Kenya will factor in his selling price the tax on electricity, audit services, legal services, purchase of equipment etc. In addition to the tax charged on the raw materials used in the manufacture of his products. Therefore though the tax passed to this manufacturer by suppliers of each raw material may be small, the tax he will factor on the selling price of his products will be not be small because he will include the tax charged for each raw material and the tax on the services mentioned above.

 
If the diffusion theory holds true, tax the government would never have to worry about the incidence of indirect taxes. It would just impose taxes knowing that the burden on each person in the society will not be felt because of how insignificant the tax will be. 

This theory is, in my opinion, useless in tax policy, law and practice.