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Chapter 18: Problem 8

Governments often have multiple objectives in imposing a tax. In each part of this question, use a demand and supply graph to illustrate your answer. a. If the government wants to minimize the excess burden from excise taxes, should these taxes be imposedon goods that have price-elastic demand or on goods that have price-inelastic demand? b. Suppose that rather than minimizing excess burden, the government is most interested in maximizing the revenue it receives from the tax. In this situation, should the government impose excise taxes on goods that have price- elastic demand or on goods that have price-inelastic demand? c. Suppose that the government wants to discourage smoking and drinking alcohol. Will a tax be more effective in achieving this objective if the demand for these goods is price elastic or if the demand is price inelastic?

Short Answer

Expert verified
a. If the government aims to minimize the excess burden from excise taxes, these should be imposed on goods that have price-inelastic demand. b. If the government is interested in maximizing the revenue it receives from the tax, it should impose excise taxes on goods with price-inelastic demand. c. If the government wants to discourage consumption of certain goods, a tax will be more effective if the demand for these goods is price elastic.

Step by step solution

01

Define Price Elasticity and Inelasticity

Price elasticity of demand measures the responsiveness of the quantity demanded to a change in the price of a good. If the quantity demanded changes significantly in response to price changes, demand is said to be elastic. If it changes very little, demand is inelastic.
02

Taxes and Price-elastic demand

If the government aims to minimize the excess burden of excise taxes, it would choose to tax goods with an inelastic demand. The excess burden of taxation falls more on the side of the market that is less elastic, meaning that consumers or producers are less able to respond to the tax by changing the quantity they buy or sell. Thus, in the case of price-inelastic demand, consumers will continue buying almost the same amount, making the excess burden of the tax smaller.
03

Maximizing Revenue

If the aim is to maximize the revenue from the tax, the government would again choose to tax goods with an inelastic demand. This is because consumers' demand for these goods does not decrease significantly when the price increases due to the tax. The revenue from the tax is the tax per unit times the number of units sold, so it will be larger when more units are sold as the case with inelastic demand.
04

Taxation to Discourage Consumption

If the government intends to discourage smoking or drinking alcohol, a tax would be more effective if the demand for these goods is price elastic. With elastic demand, consumers are more responsive to price changes. Thus, an increase in price due to a tax will lead more consumers to decrease their consumption of these goods.

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Most popular questions from this chapter

Briefly discuss the effect of price elasticity of supply and demand on tax incidence.

(Related to the Chapter Opener on page 600 ) In 2017 , the Trump administration proposed changes to the federal tax code, including reducing the top corporate income tax rate from 35 percent to 15 percent. An article in the Wall Street Journal noted, "A tax overhaul could give companies more incentive to invest." a. What type of investments is the article referring to? Why would cutting the corporate income tax rate lead companies to engage in more investment? b. Some policymakers and economists are critical of cuts in the corporate income tax rate because they argue that such cuts increase income inequality. Does the incidence of the corporate income tax matter in evaluating this argument? Briefly explain.

Cecil Bohanon, an economist at Ball State University, and Brian Pizzola, an economist with the accounting firm Ernst \& Young, used a proposed tax on income earned by credit card lenders in Minnesota to explain how tax incidence is determined. The tax, which state lawmakers did not pass, would have been imposed on lenders who charged credit card customers more than 15 percent interest on their balances. Bohanon and Pizzola explained that many of those who paid high interest rates were consumers with fewer other sources of credit, and there was nothing to prevent lenders from further raising interest rates after the tax was imposed. John Spry, an economist at St. Thomas University, stated that the proposed tax was "highly regressive \(\ldots\) twenty percent of the new tax would be paid by Minnesota families with the lowest 10 percent of income. Thirty-seven percent of the tax would be paid by families with the lowest 20 percent of income." a. Explain why John Spry believed that the proposed tax would have been "highly regressive." b. Do Bohanon and Pizzola believe the elasticity of demand of those who would have been most affected by the tax was more or less elastic than the elasticity of supply of credit card lenders? Briefly explain.

(Related to the Chapter Opener on page 600) In a column in the Washington Post, Robert J. Samuelson wrote, "As for what's caused greater inequality, we're also in the dark. The Reagan and Bush tax cuts are weak explanations, because gains have occurred in pretax incomes.... Up to a point, inequality is inevitable and desirable." a. What are pretax incomes? b. Do you agree with Samuelson's argument that income inequality may be inevitable and desirable? Briefly explain.

What is the public choice model?
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