effectoftax - 1 The effect of a commodity tax Suppose that...

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October 24 2006 1 The e ff ect of a commodity tax Suppose that a government imposes a tax on a non-traded commodity. The assumption that the commodity is non-traded means that domestic supply equals domestic demand for this commodity. In contrast, with trade, domes- tic supply and demand di ff er because of imports or exports. As a matter of common sense, it might seem that it matters whether consumers or produc- ers are charged the tax. The prominence of the Polluter Pays Principal also suggests that it is important which agent is charged with paying for environ- mental damage. However, in a competitive equilibrium, the outcome — the equilibrium price and quantity and thus the consumer and producer surplus — is exactly the same regardless of whether the tax is levied on consumers or producers. In addition, both producers and consumers e ff ectively end up paying part of the tax. This equivalence between consumer and producer taxes has implications for optimal policy to remedy environmental externalities. This chapter be- gins by explaining what it means to say that the two taxes are equivalent, and then explains the relevance of this result to environmental policy. The next section explains why the consumer and producer taxes are indeed equivalent, and shows how to measure the e ff ect of a tax. What does it mean to say that one agent, e.g. producers, "e ff ectively" pays part of the tax that is levied on the other agent, e.g. consumers? Suppose that in the absence of a tax, the equilibrium price is $12 and the supply and demand is 100 units. Suppose that a tax of $2 per unit is imposed on consumers. Does the imposition of this tax mean that the price consumers pay rises to $12+$2=$14? In general, the answer is "no". The tax does increase the price that consumers pay, but (in general) this higher price decreases the amount that they demand. In order for producers to want to decrease the amount that they supply, the price that producers receive must fall. The percentage of the tax that consumers pay is called the consumer incidence of the tax, and the percentage that producers pay is the producer incidence. Consider the following example, in which the $2 tax causes the tax- inclusive price that consumers face to rise from $12 to an equilibrium of $13.50. This higher price reduces their demand. In order for supply to 1
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fall by enough to maintain supply equal to demand, the price that producers receive must have fallen. In this example, it must have fallen to $11.50, since the tax drives a $2 wedge between the consumer (tax-inclusive) price and the producer price. The di ff erence in the tax-inclusive price paid by consumers and the price received by producers is $13.50-$11.50=$2, the amount of the unit tax. Consumers "e ff ectively pay" the share 13 . 5 12 tax = 1 . 5 2 = 0 . 75 , or 75% of the tax, and producers "e ff ectively pay" the remaining 25% of the tax. The tax causes the consumer price to raise by 75% of the tax, and it causes the producer price to fall by 25% of the tax. In this example, the tax incidence on consumers is 75% and the tax incidence on producers is 25%.
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