Taxes Market Equilibrium Chapter 6 How Taxes on

Taxes & Market Equilibrium Chapter 6

How Taxes on Buyers (and Sellers) Affect Market Outcomes • When a good is taxed, the quantity sold is smaller • Buyers and sellers both share the tax burden • Types of Taxes: – Sales Tax: tax on most goods (usually % of price) – Excise Tax: taxes on specific goods (ex: cigarettes, gasoline, etc…) • Why tax? – To raise Government Revenue or – To decrease consumption of a good (cigarettes)

Elasticity & Tax Incidence • Tax incidence is the study of who bears the burden of a tax • Taxes always result in a change in market equilibrium • Buyers pay more & sellers receive less – regardless of whom the tax is levied on!

Example: Tax on Sellers • Government places a tax on ice cream of. 50 cents • Does the tax shift the supply or demand curve? • Demand Curve is not affected – Determinant of demand did not change (TIPSEN ) • Supply Curve will shift left – Taxes is a determinant of supply (TINE & TP)

Tax on Sellers Price of Ice-Cream Price Cone buyers pay $3. 30 3. 00 Price 2. 80 without tax S 2 Equilibrium with tax S 1 Tax ($0. 50) A tax on sellers shifts the supply curve upward by the amount of the tax ($0. 50). Equilibrium without tax Price sellers receive TINE & TP Demand, D 1 Taxes are a Determinant of supply 0 90 100 Quantity of Ice-Cream Cones

Tax on Buyers Price of Ice-Cream Price Cone buyers pay $3. 30 Price 3. 00 2. 80 without tax Price sellers receive Supply, S 1 Equilibrium without tax Tax ($0. 50) New Equilibrium with tax A tax on buyers shifts the demand curve downward by the size of the tax ($0. 50). D 1 D 2 0 90 100 Quantity of Ice-Cream Cones

Elasticity determines Tax Incidence • In what proportions is the burden of the tax divided? • How do the effects of taxes on sellers compare to those levied on buyers? • It depends on the elasticity of demand & the elasticity of supply

Inelastic Demand (a) Inelastic Demand, Elastic Supply Price 1. When supply is more elastic than demand. . . Price buyers pay Supply Tax 2. . the incidence of the tax falls more heavily on consumers. . . Price without tax Price sellers receive 3. . than on producers. 0 Demand Quantity

Inelastic Supply (b) Inelastic Supply, Elastic Demand Price 1. When demand is more elastic than supply. . . Price buyers pay Supply Price without tax 3. . than on consumers. Tax Price sellers receive 0 2. . the incidence of the tax falls more heavily on producers. . . Demand Quantity

So, how is the burden of the tax divided? The burden of a tax falls more heavily on the side that is less elastic S D The Steeper Curve pays more tax!

Tax Summary • A tax on buyers shifts D-curve • A tax on sellers shifts S-Curve • The incidence of a tax does not depend on whether the tax is levied on buyers or sellers • It depends on the price elasticities of supply and demand. • The majority of the tax burden falls on the side of the market that is less elastic (more inelastic, steeper curve pays more of tax)

Worksheet on Excise Taxes • Lesson 4, Activity 21

Perfectly Inelastic Demand D S 1 S P 2 Tax P 1 -----Tax Revenue -----Q 1