Question

Describe what is meant by an excise tax. Give an example. What is meant by the incidence of a tax?

What is the impact of an excise tax on quantity and price? Provide a detailed example.

What happens when an excise tax is paid mainly by consumers?

Describe what happens when an excise tax is paid mainly by producers?

What are the costs of taxation? Provide a detailed discussion.

Describe how deadweight loss changes when supply is elastic and inelastic

Explain the difference between the benefits principle and the ability-to-pay principle.

Answer 1

Excise Tax . Incidence of Excise tax :-

Excise tax refers to an indirect type of taxation imposed on the manufacture, sale or use of certain types of goods and products .

The incidence of tax refers to the burden of paying tax which means on whom the real burden of paying the tax Has Fallen. The incidence of excise tax depends upon the elasticity of demand and supply of that certain good on which the excise tax is imposed .

1) if the supply is less elastic than the elasticity of demand the incidence of tax will fall on the producers.

2) if the supply is more elastic than the elasticity of demand the incidence of tax will fall on the consumers .

Impact of Excise tax :-

The main impact of excise tax on the price of the good is :-

1) It raises the prices paid by the buyers .

2) It reduces the prices received by the seller .

The consolidated effect is that excise tax reduces both the consumer and producer surplus .

With the increase in prices the consumer tends to buy less or the supplier tends to supply less leading to the reduction of equilibrium quantity.

For example the initial price of a good was Dollar 80 at which the market equilibrium was formed at 1,000 units of that good . Now due to impose addition of excise tax of dollar 20 the price will rise to dollar hundred . This will induce the buyers to purchase less as there is an inverse relationship between the prices of the good and the demand of the good and the suppliers to supply less as it has become less profitable for the suppliers to sell these goods .Thus they will choose to supply less of the above good leading to a consolidated effect of decrease in equilibrium quantity . Therefore imposition of excise tax has two major effects :-

1) It increases the price of the good.

2. It decreases the market equilibrium quantity of the good.

Excise tax incidence on consumers:-

Suftly C A Tax D2 Quandry CI CO

In the given graph S represents the supply curve, D1 represents the initial demand curve and D2 represent the after tax demand curve. Let us without any tax the price of the good was P1 and the the equilibrium was formed at point A at quantity Q1 . Now when the excise tax is imposed the new price becomes P2 and the new equilibrium is formed at point B at Q2 quantity. The consolidated effect is seen as when the buyer pays P2 amount of price for the good , P amount of price goes to the seller while the difference between p and P2 goes to the government. At initial equilibrium the seller used to get P1 amount of price but now has lost an amount equal to the difference between p and P1. Thus the incidence of tax is being levied on consumers.

Excise tax incidence on producers :-

S1 K Puica

In the above graph the market was at equilibrium at point a where the equilibrium quantity was Q1 and equilibrium price of P1 . As soon as the imposition of tax takes place the price of the good becomes P2 and the supply of shifts from S1 to S2 forming a new equilibrium at point B and reducing the equilibrium quantity to Q2 .the the difference between P1 and P2 is the Tax amount that goes to the government and the above the graph represents the incidence of tax that falls on producers.

Costs of taxation :-

The cost of taxation is the administrative cost of the resources and facilities used by government to collect the tax . It must be noted that the dead weight loss include the administrative costs of collection of tax .

Dead weight loss with elastic supply :-

Tarx D Puarthes

When the supply of the good is relatively more elastic than the demand of the good than the supply curve shifts from S1 to S2 shifting the equilibrium to the left thereby increasing the price from P1 to P2 and decreasing the equilibrium quantity from Q1 to Q2. The deadweight loss in this case is represented by the shaded area given in the above figure.

Dead weight loss with inelastic supply :-

DI D2 uanky cr

When the supply of the good is relatively more inelastic and the demand of the good is more elastic than the supply, in such a case instead of shifting the supply curve the demand curve shifts from D 1 to D2 thereby increasing the price to P2 and decreasing the equilibrium quantity to Q2 . the shaded area in the above diagram that is enclosed by points A B and C represents the deadweight loss of imposition of taxation.

Difference between Benefits principle and ability to pay principle :-

The benefit principle supports the fact that those who benefits from the public spending should bear the burden of tax and pay for the tax . However it does not takes into account the financial conditions and the marginally suppressed class who are unable to bear such burden where are the ability to pay principle of tax fairness supports the the thought that the one who has the ability to pay higher taxes should pay more taxes and the one who has the ability to pay less taxes should pay comparatively low amount of taxes. It generally does not takes into account the the benefits derived by the people who are receiving the services on which the tax revenue is being spent.