Chapter 7: Taxes.
Excise tax: An excise tax is a tax on sales of a good or service. E.g. excise taxes on cigarettes, gasoline,
foreign made trucks etc.
The effect of taxes on quantities and prices:
(Insert Figure 7-1)
Pre-tax, sellers were willing to sell 10,000 rooms at the equilibrium price of $80. Also, as per the supply
curve, they were willing to supply 5,000 rooms at the equilibrium price of $60.
When the government decides to impose a tax of $40 on each room rented, the supply curve shifts
upwards by $40. This means that the sellers still receive the same profit of $60 but charge a price of
$100. The new equilibrium price and quantity are 5,000 rooms at a price of $100. This is depicted by the
graph in figure 7-2. Due to a sales tax, the demand curve does not shift but the supply curve moves
upwards. Furthermore, the sellers who were receiving $80 per room before the tax was applied now
make a profit of $20 while buyers who were renting rooms at the price of $80 are now paying $100 per
room. In a way, a sales tax drives a wedge similar to a quota. It results in fewer transactions at a higher
price. Due to this wedge, consumers pay more while producers receive less.
(Insert Figure 7-2)
Taxes lead to inefficiencies as transactions which would have taken place otherwise no longer take
place. Taxes result in missed opportunities.
The Incidence of a tax is a measure of who really pays it.
In a tax, half the price is paid by consumers and half is paid by producers. Regardless of whether the tax
is levied on consumers or producers, the incidence of the tax is evenly split between them.
If a government wanted a tax levied on consumers instead of producers, the demand curve will shift
downward. The price, however, paid would still be $100, with the tax evenly split between producers
and consumers. This concept is depicted in figure 7–3.
(Insert figure 7-3)
In practicality, however, the burden of a tax is split unevenly between a consumer and a producer. This
depends on the price elasticity of supply and the price elasticity of demand.
When the excise tax is mainly paid by consumers:
(Figure 7-4)
To understand this, we take the example of gasoline whose equilibrium price is $2. But after the
imposition of tax, the price of gasoline goes up to $2.95 which can be understood by shifting the supply
curve $1 by using the y-axis as reference point. As seen in the figure, the majority of the tax burden is
shared by consumers. This is because the price elasticity of demand is low i.e. demand changes very
little with change in price while the price elasticity of supply is high i.e. supply changes significantly with
changed in price. In this case, a $0.95 of $1 is paid by consumers while the rest is paid by producers. This
illustrated an important principle of taxation. When the price elasticity of demand is low, and the price
elasticity of supply is high, the burden of an excise tax falls mainly on consumers. This is because
consumers have little alternatives while producers have many substitutes. This results in the party with
little options ending up paying the majority of the tax while the party with a greater number of choices
paying little tax.
When an excise tax is mainly paid by producers:
(Figure 7-5)
To understand this, we take the example of a downtown parking whose market equilibrium price is $6.
The price elasticity of supply is very low because the parking lots have very few other alternate choices
while the price elasticity of demand is high because consumers have a lot of other options. This makes
