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1 Sales and Excise taxes

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2 A sales tax on consumers P Q D1 P1 Q1 Say that at a certain time there is no sales tax on an item. Then if the price is P1, Q1 is the quantity demanded. We will consider a sales tax one where the consumer pays a tax directly to the government.

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3 A sales tax on consumers With a sales tax not only does the consumer have to pay the merchant, but money must be sent to the government as well. The amount paid to the merchant is called the price of the product. The amount the customer ultimately takes out of their pocket for the product is the price plus the tax. Your first inclination, when I say the product now has a lump sum tax of 10 cents per unit on it, may be to say the demand curve should shift up by 10 cents - P is paid to the merchant and the tax is added on and paid to the government. Lets look at how we really want to handle this situation.

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4 A sales tax on consumers Without a sales tax the amount the consumer pays the merchant and the amount taken out of pocket are the same. What really matters to the consumer is how much is taken out of the pocket. Say P1=50 cents and Q1=2 cups of coffee per day. Then before a tax the consumer is willing to pay $1 per day for coffee. Now say a tax of 10 cents per cup is imposed on the consumer. But the consumer wants 2 cups of coffee when $1 comes out of the pocket. With this tax the only way this is going to happen is if the price per cup is now 40 cents.

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5 A sales tax on consumers This doesnt mean the seller will lower the price to 40 cents!!! It just means the consumer will not demand 2 cups unless the price is 40 cents per cup. Thus the demand curve shifts DOWN by the amount of the tax. In our analysis we like to draw the demand curve both before and after the tax.

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6 effect of sales tax on the demand curve P Q D1 D2 D1 = demand curve before tax D2 = demand curve after tax Note 1) If Pbt is the price before the tax the quantity demanded would be Q1. 2) With the tax Q1 will only still be demanded if the price is Pat. Then the Q1 Pbt = Pat +tax Pat consumer will still only have to take out of their pocket Pbt for Q1.

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7 excise tax If a lump sum excise tax is imposed then the seller still needs to get P1 for their own efforts in order to supply Q1. This means the price in the market will have to be P1 plus the tax to supply Q1. Thus the supply curve shifts up by the amount of the tax. Q S1 P P1 Q1 P2 = P1 + tax S2

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8 Something seems weird about the sales tax and the excise tax when I compare the two. The sales tax is paid by the consumer. So prices on the demand curve WILL NOT include the sales tax because consumers know after they take the item they will also have to pay the tax to the government. But, consumers only want to pay a certain amount for a good or service, regardless of taxes or not. The excise tax is paid by the producer. So prices on the supply curve WILL include the excise tax because after the government gets the tax the suppliers still need to get the amount they want for the item sold.

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9 Equilibrium Equilibrium in a market is a situation where 1) Buyers can buy all they want at the price considered and 2) Sellers can sell all they want at the price considered. If both situations do not occur there is a force for change in the market. Equilibrium is the absence of a force for change. Equilibrium in a market occurs where supply and demand cross.

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10 effect of sales tax on the market P Q P2 + tax P1 P2 S1 D1 D2 S1 = supply curve D1 = demand curve before tax D2 = demand curve after tax P1, Q1 = initial equil. P2, Q2 = new equil. Note 1) Q2 < Q1 - lower output 2) P2 < P1 - lower market price 3) Consumer pays P2 to the seller and pays a tax on each unit purchased to the government, the total paid per unit is P2 + tax. Q2 Q1

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11 effect of sales tax on the market 4) Tax = P2 + tax - P1 + P1 - P2 Amount of increase in per unit pay out made by the consumer. Amount of decrease in the per unit amount seller receives.

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12 effect of excise tax on the market P Q P3 P1 P3 - tax S1 D1 S1 = supply curve before tax D1 = demand curve S2 = supply curve after tax P1, Q1 = initial equil. P3, Q2 = new equil. Note 1) Q2 < Q1 - lower output 2) P3 > P1 - higher market price 3) tax = P3 - P1 + P1 - P3 + tax = P3 – P1 + P1 – (P3 – tax) Q2 Q1 S2 increase in amount paid by consumer on per unit basis decrease in amount seller keeps after the tax, per unit

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13 Comparing excise and sales tax P Q S1 D1 Q2 Q1 S2 D2 If the excise tax and the sales tax are of the same amount, but only one is imposed, we would end up at Q2. Pd is what consumers take out of pocket, Ps is what sellers keep and Pd - Ps is the tax(all on a per unit basis). Pd Ps The economic incidence of a marketplace tax is independent of its legal incidence. In other words, sales or excise taxes have the same real impact on the market.

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14 Hey you ever heard of a wedgie, or what is sometimes called a herman? Well, I am not going to talk about that now. I wanted to talk about a wedge. In our supply and demand graph we have seen that when a per unit tax is imposed on the buyer the demand shifts down by the amount of the tax and when a tax is imposed on the seller the supply shifts up by the amount of the tax. This vertical line here is the amount of the tax. I have shown my right hand as well because I am going to push the line with my hand into a supply and demand graph on the next few slides and WEDGE the tax into the S & D curves. Here goes.

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15 Q P S D

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16 Q P S D

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17 Q P S D

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18 Q P S D So, you can see by the graph, when we wedge the tax into the graph we can see either the demand shifts down by this amount or the supply shifts up by this amount. We end up at the same market quantity and our story is the same as before.

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