Elasticity and tax revenue

Posted 2023-07-06 20:21:10

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Key points

Tax incidence is the manner in which the tax burden is divided between buyers and sellers.
The tax incidence depends on the relative price elasticity of supply and demand. When supply is more elastic than demand, buyers bear most of the tax burden. When demand is more elastic than supply, producers bear most of the cost of the tax.
Tax revenue is larger the more inelastic the demand and supply are.

The burden of tax

Depending on the circumstance, the burden of tax can fall more on consumers or on producers.

In the case of cigarettes, for example, demand is inelastic—because cigarettes are an addictive substance—and taxes are mainly passed along to consumers in the form of higher prices.

The analysis, or manner, of how the burden of a tax is divided between consumers and producers is called tax incidence.

Elasticity and tax incidence

Typically, the incidence, or burden, of a tax falls both on the consumers and producers of the taxed good. But if we want to predict which group will bear most of the burden, all we need to do is examine the elasticity of demand and supply.

In the tobacco example above, the tax burden falls on the most inelastic side of the market. If demand is more inelastic than supply, consumers bear most of the tax burden. But, if supply is more inelastic than demand, sellers bear most of the tax burden.

Think about it this way—when the demand is inelastic, consumers are not very responsive to price changes, and the quantity demanded remains relatively constant when the tax is introduced. In the case of smoking, the demand is inelastic because consumers are addicted to the product. The seller can then pass the tax burden along to consumers in the form of higher prices without much of a decline in the equilibrium quantity.

When a tax is introduced in a market with an inelastic supply—such as, for example, beachfront hotels—sellers have no choice but to accept lower prices for their business. Taxes do not greatly affect the equilibrium quantity. The tax burden in this case is on the sellers. If the supply were elastic and sellers had the possibility of reorganizing their businesses to avoid supplying the taxed good, the tax burden on the sellers would be much smaller, and the tax would result in a much lower quantity sold instead of lower prices received.

People often think that excise taxes hurt mainly the specific industries they target. But ultimately, whether the tax burden falls mostly on the industry or on the consumers depends simply on the elasticity of demand and supply.