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Chapter 18: Problem 13

Suppose the government eliminates the federal income \(\operatorname{tax}\) and replaces it with a consumption tax. With a consumption tax, individuals pay a tax on only the part of their income they spend rather than save. Think about the effect of this change on the market for automobiles. Can you necessarily tell what will happen to the price and quantity of automobiles? Briefly explain.

Short Answer

Expert verified
Without exact data about consumers' preferences and the size of both effects (income-effect and substitution-effect), it's not possible to say with certainty what will happen to the price and the quantity of automobiles in the market. The outcome would result from the net effect of these two opposing influences on the consumers' behavior.

Step by step solution

01

Understand the tax changes

A consumption tax taxes the part of the income that individuals spend rather than save. This contrasts with an income tax which taxes the total income. With a consumption tax, if an individual decides to save part of their income, that part is not taxed. This fundamental difference will have impacts on the consumer's behavior.
02

Analyze the substitution-effect

Switching to a consumption tax makes saving more attractive since saved money is not taxed. So, part of the income that was previously spent (and now is taxed) might start to be saved and thus not taxed. This substitutes consumption with saving which in turn might negatively impact consumption goods' demand, including automobiles.
03

Analyze the income-effect

On the other hand, due to the substitution toward savings, individuals can also feel that their purchasing power or 'true income' increased, since if they save money, they are not taxed and can use more money in the future. This effect can increase the demand for normal goods including automobiles.
04

Equilibrium effect on price and quantity of automobiles

The final effect on the price and quantity of automobiles will depend on the sum of these substitution and income effects. If the substitution effect dominates the income effect (more people save, thus demanding less cars), the demand will decrease leading to lower price and quantity of sold automobiles. However, if the income effect dominates (people feel wealthier and increase their demand), there'll be an increase in both automobile prices and quantities. Without specific data on consumers' preferences, it is impossible to predict with certainty what will happen.

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