Question

In each of the following cases involving taxes, explain: (i) whether the incidence of the tax falls more heavily on consumers or producers, (ii) why government revenue raised from the tax is not a good indicator of the true cost of the tax, and (iii) how deadweight loss arises as a result of the tax. a. The government imposes an excise tax on the sale of all college textbooks. Before the tax was imposed, 1 million textbooks were sold every year at a price of \$50. After the tax is imposed, 600,000 books are sold yearly; students pay \(\$ 55\) per book, \(\$ 30\) of which publishers receive. b. The government imposes an excise tax on the sale of all airline tickets. Before the tax was imposed, 3 million airline tickets were sold every year at a price of \(\$ 500\). After the tax is imposed, 1.5 million tickets are sold yearly; travelers pay \(\$ 550\) per ticket, \(\$ 450\) of which the airlines receive. c. The government imposes an excise tax on the sale of all toothbrushes. Before the tax, 2 million toothbrushes were sold every year at a price of \(\$ 1.50\). After the tax is imposed, 800,000 toothbrushes are sold every year; consumers pay \(\$ 2\) per toothbrush, \(\$ 1.25\) of which producers receive.

Short answer

Explain how deadweight loss arises in each case. Answer: In the case of college textbooks, the incidence of the excise tax falls more heavily on producers (publishers). For airline tickets, the tax burden is equally distributed between consumers and producers. In the case of toothbrushes, the tax burden falls more heavily on consumers. Deadweight loss arises in each case due to the reduction in the quantity of goods sold, leading to losses in consumer surplus and producer surplus.

Step-by-step solution

Identify the tax amount and change in price and quantity

Before the tax, 1 million textbooks were sold at a price of \(50. After the tax is imposed, 600,000 books are sold yearly; students pay \)55 per book, \(30 of which publishers receive. So the tax amount is \)55 - \(30 = \)25.

Determine the incidence of the tax

Since the price for the students increased by \(5, and the publishers receive \)20 less per textbook, the burden falls more heavily on the producers (publishers).

Government revenue vs. true cost

The revenue from the tax is 600,000 * \(25 = \)15,000,000. However, this is not a good indicator of the true cost because it does not account for the reduction in the number of textbooks sold and the lost consumer and producer surplus.

Deadweight loss

Deadweight loss arises due to the reduction in the quantity of textbooks sold which leads to a loss in consumer surplus and producer surplus. In this case, the deadweight loss is associated with the 400,000 textbooks that are no longer sold because of the tax. #Case b: Airline tickets#

Identify the tax amount and change in price and quantity

Before the tax, 3 million airline tickets were sold yearly at a price of \(500. After the tax, 1.5 million tickets are sold yearly, with travelers paying \)550 per ticket, and airlines receiving \(450. The tax amount is \)550 - \(450 = \)100.

Determine the incidence of the tax

The price for travelers increased by \(50, and the airlines receive \)50 less per ticket. The burden of the tax is equally distributed between consumers and producers in this case.

Government revenue vs. true cost

The revenue from the tax is 1.5 million * \(100 = \)150,000,000. However, as with the textbooks case, this does not account for the reduction in the number of airline tickets sold and the lost consumer and producer surplus.

Deadweight loss

Deadweight loss arises due to the reduction in the quantity of airline tickets sold, leading to a loss in consumer surplus and producer surplus. In this case, the deadweight loss is associated with the 1.5 million airline tickets that are no longer sold due to the tax. #Case c: Toothbrushes#

Identify the tax amount and change in price and quantity

Before the tax, 2 million toothbrushes were sold yearly at a price of \(1.50. After the tax, 800,000 toothbrushes are sold yearly, with consumers paying \)2, and producers receiving \(1.25. The tax amount is \)2 - \(1.25 = \)0.75.

Determine the incidence of the tax

The price for consumers increased by \(0.50, and producers receive \)0.25 less per toothbrush. The burden of the tax falls more heavily on the consumers in this case.

Government revenue vs. true cost

The revenue from the tax is 800,000 * \(0.75 = \)600,000. Yet again, this does not account for the reduction in the number of toothbrushes sold and the lost consumer and producer surplus.

Deadweight loss

Deadweight loss arises due to the reduction in the quantity of toothbrushes sold which leads to a loss in consumer surplus and producer surplus. In this case, the deadweight loss is associated with the 1.2 million toothbrushes that are no longer sold due to the tax.

Key concepts

Deadweight Loss

Deadweight loss is a concept that illustrates the inefficiency created in a market due to a tax. It is the reduction in total welfare or economic efficiency, which occurs when the quantity of a good produced and consumed is reduced below the socially optimal level. In the case of excise taxes on goods like textbooks, airline tickets, or toothbrushes, deadweight loss arises because these taxes increase prices and decrease the quantity sold.

• For example, textbook sales drop from 1 million to 600,000 annually due to the tax, meaning 400,000 potential transactions that would benefit consumers and producers are lost.
• Similarly, the sale of airline tickets and toothbrushes see reductions, leading to less overall trade and lost opportunities for market participants.

This loss isn't offset by any gain in welfare for others and represents pure economic waste.

Consumer Surplus

Consumer surplus is the difference between what consumers are willing to pay for a good or service and what they actually pay. It shows the benefit received by consumers because they can purchase a product for less than the maximum price they're willing to pay.
In our examples, excise taxes reduce consumer surplus by increasing the price paid by consumers and decreasing the quantity of goods consumed.

• Textbook buyers once paid $50 but now pay $55, narrowing the gap between their willingness to pay and the actual price.
• The same pattern occurs for airline ticket purchasers and toothbrush buyers.

These higher prices diminish the extra satisfaction that consumers derive from purchasing these goods at favorable prices, thus reducing consumer welfare.

Producer Surplus

Producer surplus represents the difference between the price producers are willing to accept for a good or service and the actual price they receive. It reflects the benefit to producers from selling goods at a market price that is higher than their minimum acceptable price.
Due to a tax, this surplus diminishes because the price producers can charge decreases, even as the ultimate price consumers pay may increase.

• For instance, textbook publishers originally received $50 per book but can only charge $30 post-tax.
• Airlines and toothbrush producers face a similar squeeze on their margins.

This reduction in producer surplus curtails the economic benefits to sellers and discourages future production and investment.

Government Revenue

Government revenue from an excise tax is the product of the tax rate and the payers' taxable capacity—namely, how much they continue to buy even after the tax. This revenue is regularly emphasized as the primary benefit of such policies.
Nonetheless, it doesn't fully account for the broader economic ramifications of tax enforcement.

• For instance, textbook tax revenue is $15 million, but it ignores the economic activity lost from reduced sales.
• Government revenue does not offset the deadweight loss nor recover lost consumer and producer surplus.

Thus, while tax revenue helps fund governmental projects, it doesn't capture the total cost paid by the economy through inefficiencies introduced by the tax.

Excise Tax

An excise tax is a fixed additional charge levied on specific goods or services, often unrelated to the goods' prices. It directly impacts production and consumption by raising production costs, influencing demand, or both.
With the imposition of an excise tax, market dynamics shift substantially. This is mainly because the tax makes a good more expensive, which typically reduces demand, as seen with textbooks, airline tickets, and toothbrushes.

• Equilibrium quantity drops, leading to fewer goods being traded.
• Prices for consumers rise, while producers receive less per unit, redistributing the cost burden unevenly between the two.
• Often, both sides share the tax burden to different degrees, depending on elasticity.

Excise taxes are thus significant instruments of fiscal policy, but they also disrupt optimal allocation and market equilibrium.