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Price Elasticity and Tax Incidence

CHAPTER

5 Appendix

© 2003 South-Western/Thomson Learning

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Exhibit 13: Effect of Different Demand Elasticities on Sales Tax Incidence

Since the government now gets $0.20 for each ounce sold, that amount must be added to the original supply curve to get a supply curve that includes the tax •the shift in the supply curve from S to St

reflects the decrease in supply resulting from the tax •the effect of the tax is to decrease the supply by the amount of the tax.

D

(a) Less elastic demand

Pri

ce p

er o

un

ce

Millions of ounces per day

10

$1.00

S

0

Before the tax is imposed, the intersection of demand and supply yields a market price of $1.00 per ounce and a market quantity of 10 million ounces per day.

St

$1.15

9

$0.20 Tax

Suppose a tax of $0.20 is imposed on each ounce sold. Recall that the supply curve represents the amount that producers are willing and able to supply at each price.

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Demand Elasticity and Tax Incidence

D

(a) Less elastic demand

Pri

ce p

er o

un

ce

Millions of ounces per day

10

$1.00

SSt

9

$1.15

0.95

0

The result of the tax is to raise the equilibrium price from $1.00 to $1.15 and to decrease the equilibrium quantity from 10 million to 9 million ounces.

Thus, consumers pay $1.15, or $0.15 more per ounce, and producers receive $0.95 after the tax, or $0.05 less per ounce.Consumers pay $0.15 of the tax as a higher price and producers pay $0.05 as a lower receipt.

The shaded area shows the tax collected, which equals the tax per ounce of $0.20 times the 9 million ounces sold $1.8 million in tax revenue per day.

Graphically, the upper shaded area shows the tax paid by the consumers through a higher price.

$0.20 Tax

The lower portion showing the tax paid by producers through a lower net-of-tax receipt.

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Demand Elasticity and Tax IncidenceWhen demand is more elastic: •consumers reduce their quantity demanded more sharply in response to a price change, •producers cannot as easily pass the tax along as a higher price. •Here the tax increases the price by $0.05, to $1.05, and the net-of-tax receipt to suppliers declines by $0.15 to $0.85. Total tax revenue equals $0.20 per ounce times 7 million sold, or $1.4 million per day.

Again, the upper rectangle shows the portion of the tax paid by consumers through a high price.

The lower rectangle shows the portion paid by producers through a lower net-of-tax receipt.

D

(b) More elastic demand

Pri

ce p

er o

un

ce

Millions of ounces per day

10

$1.00

SSt

9

$1.05

0.85

0

$0.20 Tax

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Demand Elasticity and Tax Incidence

Generally, as long as the supply curve slopes upward

The more price elastic the demand, the more the tax is paid by producers as a lower net-of-tax receipt and the less it’s passed on to consumers as a higher price

The less price elastic the demand, the more the tax is paid by consumers as a higher price and the less is paid by producers as a lower net-of-tax receipt

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Demand Elasticity and Tax Incidence

Additionally, the total tax revenue is lower when demand is more elastic

Because tax revenue falls as the price elasticity of demand increases, governments tend to tax products with inelastic demand

CigarettesLiquorGasolineGambling

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Exhibit 14: Effects of Different Supply Elasticities on Sales Tax Incidence

$1.00

$1.05

D''

(b) Less elastic supply

Pri

ce p

er o

un

ceMillions of

ounces per day10

S´´St''

9

0.85

0

$0.2

0 T

ax

(a) More elastic supply

Pri

ce p

er o

un

ce

Millions of ounces per day

$1.00S'

St'

8

$1.15

0.95

0

$0.20 Tax

D''

10 9

The same demand curve appears in both panels.

Equilibrium price = $1.00, and equilibrium = 10 million ounces of tea leaves per day.

Sales tax of $0.20 per ounce is imposed, supply decreases in both (a) and (b) to reflect the tax.

In (a) the price rises to $1.15 or $0.15 above the pretax price of $1.00, while in (b) the price increases by only $0.05

More tax is passed on to consumers where supply is more elastic (panel a). Less tax is passed on to consumers where supply is less elastic (panel b).

$0.15 $0.05

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Supply Elasticity and Tax Incidence

Generally, as long as the demand curve slopes downward

The more elastic the supply, the less the tax is paid by producers as a lower net-of-tax receipt and the more is passed on to consumers as a higher priceThe less elastic the supply, the more the tax is paid by producers as a lower net-of-tax receipt and the less is passed on to consumers as a higher price