1 Excise Tax on a Market

2 excise tax An excise tax is a tax on the seller of a product. We treat the tax as a cost of doing business. If there is no tax the seller will offer Q1 for sale when the price is P1. In other words the seller is indicating they need P1 to supply Q1. Q S1 P P1 Q1

3 excise tax If a lump sum excise tax is imposed then the seller still needs to get P1 for their own efforts in order to supply Q1. This means the price in the market will have to be P1 plus the tax to supply Q1. Thus the supply curve shifts up by the amount of the tax. Q S1 P P1 Q1 P1 + tax S2 Note: I am not saying the price will rise by the amount of the tax, but if the price did rise by the amount of the tax the sellers would still supply Q1.

4 effect of excise tax on the market P Q P3 P1 P3 - tax S1 D1 S1 = supply curve before tax D1 = demand curve S2 = supply curve after tax P1, Q1 = initial equil. P3, Q2 = new equil. Note 1) Q2 < Q1 - lower output 2) P3 > P1 - higher market price 3) tax = P3 - P1 + P1 – (P3 – tax). Q2 Q1 S2 increase in amount paid by consumer on per unit basis decrease in amount seller is paid after the tax - per unit

5 The sellers can’t just make the buyers of the product pay all the tax (usually) because buyers, when faced with a higher price, will reduce their quantity demanded. This is why output in the market falls. The sellers reducing their supply does mean that when the new supply meets the demand the market price does go up some. But the sellers have to take some of this money and send on the tax to the government. On a per unit basis, then, the market price consumers pay goes up by less than the tax and the amount sellers get to keep in their own pocket goes down by less than the tax. Even though the sellers are taxed with an excise tax, both buyer and seller end up paying the tax.

6 Impact on economic surplus P Q P3 P1 P3 - tax S1 D1 Q2 Q1 S2 a b c d e f g h i Before the tax the consumer surplus is a + b + c + d and after the tax it is just area a. Thus consumers lose b, c and d due to the tax Before the tax the producer surplus is e + f + g + h + i, and it falls to h + i. Thus producers lose e, f and g due to the tax. Note the tax revenue is b + c + e + f.

7 Note the lose in surplus, b + c + d + e + f + g, is not totally lost. The government collects b + c + e + f. So the next lose or deadweight lose is just d and g. Note the deadweight loss occurs above the output reduction in the graph. Note here that the government imposing a tax reduces the output in the market. So, tax revenue is not collected on the old market equilibrium. It is collected on the new market equilibrium. The deadweight loss is a measure of value lost to producer and consumer. Analogy: Say a thief in the night breaks your window and takes your stereo. You lose your stereo and the window, but the thief only gets the stereo. (Government gets less than what consumers and producers lose.)