1. Homework #11 Government Finance

2. Some suggest that states are addicted to their vice taxes. This certainly might be true with a unit excise tax on cigarettes which is imposed by requiring that wholesales affix a stamp to each package of cigarettes. Use supply and demand diagrams to explain why such a tax would likely: 1) Generate significant revenue with very little excess burden or deadweight loss. 2) Have very little effect on the consumption of cigarettes and thus fail to decrease smoking. 3) Be paid mostly by smokers rather than tobacco companies, wholesalers, and retailers. 4) Achieve accountability and administrative efficiency because of statutory incidence at the wholesale level.

3. Tax Revenue Because demand is fairly inelastic, a tax will impose a relatively small amount of excess burden than if demand was elastic. In the market for cigarettes, demand is fairly inelastic as is represented by this diagram. Thus, a unit tax on cigarettes will impose a relatively small amount of burden on both suppliers and consumers when compared to a market with an elastic demand curve. However, there will be a relatively large amount of tax revenue generated as is represented by the amount change in price from P 1 to P 2 relative to the change in quantity from Q 1 to Q 2 Tax On Cigarette Market Q P Q1Q1 Q2Q2 P2P2 P1P1 1. Consumer Excess Burden Supplier Excess Burden P3P3

4. Tax Revenue Consumer Excess Burden Supplier Excess Burden Tax On Cigarette Market Q P Q1Q1 Q2Q2 P2P2 Because demand is fairly inelastic, the change in quantity from Q 1 to Q 2 is relatively small when a tax is imposed. Thus, excess burden is relatively small when compared to a market with an elastic demand curve. In other words, a tax on cigarettes only decreases the quantity purchased of cigarettes a small amount, and will not decrease smoking by very much. P1P1 2. P3P3

5. Tax Revenue Tax On Cigarette Market Q P Q1Q1 Q2Q2 P1P1 P2P2 Because demand is relatively more inelastic than supply, consumers will pay a larger proportion of the tax than producers will. The amount of tax revenue that consumers will pay is represented by the red rectangle, and the amount producers will pay is represented by the green rectangle. The portion of the tax consumers pay is represented by the difference between P1 and P2. The portion of the tax producers pay is represented by the difference between P1 and P3. P3P3 3. Consumer Excess Burden Supplier Excess Burden

6. Tax Revenue Tax On Cigarette Market Q P Q1Q1 Q2Q2 P1P1 P2P2 By imposing a statutory tax at the wholesale level, one is placing the responsibility to pay the tax on suppliers. This increases the accountability and efficiency of the tax because there are less suppliers who will be required to pay the tax than there are consumers. After the tax is placed on the suppliers, suppliers can then shift the burden of the tax on to consumers by raising the price for cigarettes. This occurs because of economic incidence where market forces decide who will bear the burden of the tax. 4. Consumer Excess Burden Supplier Excess Burden P3P3