Governments & marketsslide 7 AN IMPORTANT TAX PROBLEM Suppose the market for cigarettes is in equilibrium. Suppose the State of Michigan, in its wisdom, decides to impose a tax of $1 per pack on the sale of cigarettes. How does the tax affect the market for cigarettes?
Governments & marketsslide 8 This kind of tax can be analyzed as if it were an input price increase. The tax is similar to having to pay a higher price for some input (government services?). The tax will raise the supply curve by the amount of the tax per unit.
Governments & marketsslide 9 The tax raises the supply curve by the amount of the tax per unit pEpE QEQE S D Q price S + tax CIGARETTE MARKET This distance is exactly $1.
Governments & marketsslide 10 The reason the supply curve shifts up by exactly the amount of the tax is that price would have to rise by the full amount of the tax to induce cigarette suppliers to supply the amount they supplied before the tax.
Governments & marketsslide 11 But price will rise by less than the amount of the tax, as the following diagram shows. Go to hidden slide
Governments & marketsslide 12 The new equilibrium price must be less than $1 higher than the old price. D S $/Q D S S+Tax Exactly $1. New price
Governments & marketsslide 13 The states tax revenue is $1 times the number of units sold. p E QEQE S D Q P S + tax Q E CIGARETTE MARKET total tax collections
Governments & marketsslide 14 Tax Burden The tax burden on consumers is the part of the tax paid by consumers in terms of higher prices. The tax burden on sellers is the part of the tax paid by firms in terms of lower receipts.
Governments & marketsslide 15 Who pays the tax on cigarettes? S+Tax D S P Q Tax per unit Go to hidden slide
Governments & marketsslide 16 The burden can be exactly measured. S+Tax D S P Q Buyer's burden Seller's burden So the total tax revenue of the state is born by the buyers and sellers.
Governments & marketsslide 17 Tax burden on each is determined by the elasticities of supply and demand.
Governments & marketsslide 18 Given the demand curve, more elastic (flatter) supply means greater tax burden for consumers. Given the supply curve, more elastic (flatter) demand means greater tax burden for sellers. [Hint: Don't try to memorize these statements. Instead, make sure you can figure out each case.]
Governments & marketsslide 19 Elasticity also determines the state's tax revenue. For example: 1)The more inelastic is the demand curve, the greater will be the states tax revenue. 2)The more inelastic is the supply curve, the greater will be the states tax revenue.
Governments & marketsslide 20 The next (hidden) slide shows these principles for different elasticities of demand. When demand is more elastic: Price rises less. There's relatively more burden on sellers. The state takes in less revenue. Go to hidden slide
Governments & marketsslide 21 S D elast D inelast S Q Q $/Q Equal Pretax Sales Incidence of Per Unit Tax: Elastic and Inelastic Demand S+Tax