Price Elasticity and Tax Incidence

Exhibit 13: Effect of Different Demand Elasticities on Sales Tax Incidence 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. (a) Less elastic demand St S 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. $1.15 $1.00 $0.20 Tax • 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 Price per ounce 0 Millions of ounces per day 9 10

Demand Elasticity and Tax Incidence 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. (a) Less elastic demand St S 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. $1.15 $1.00 $0.20 Tax 0.95 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. D Price per ounce Graphically, the upper shaded area shows the tax paid by the consumers through a higher price. 0 Millions of ounces per day 9 10 The lower portion showing the tax paid by producers through a lower net-of-tax receipt.

Demand Elasticity and Tax Incidence (b) More elastic demand St S $1.05 $0.20 Tax $1.00 0.85 D Price per ounce 0 Millions of ounces per day 9 10 • When 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.

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

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 • Cigarettes • Liquor • Gasoline • Gambling

Exhibit 14: Effects of Different Supply Elasticities on Sales Tax Incidence (b) Less elastic supply (a) More elastic supply St' $0.20 Tax S' $1.15 $0.20 Tax $1.05 $0.15 $0.05 $1.00 $1.00 0.95 D'' 0.85 D'' Price per ounce Price per ounce St'' S´´ Millions of ounces per day 0 0 Millions of ounces per day 9 10 8 9 10 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 The same demand curve appears in both panels. Equilibrium price = $1.00, and equilibrium = 10 million ounces of tea leaves per day. 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). Sales tax of $0.20 per ounce is imposed, supply decreases in both (a) and (b) to reflect the tax.

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 price • The 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

Price Elasticity and Tax Incidence