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Chapter_16_v2 - Part 4 A Framework for Tax Analysis Chapter...

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Part 4 – A Framework for Tax Analysis Chapter 16 – Efficient and Equitable Taxation 1. Assuming that all other commodities (except for cable and satellite television) were untaxed, then optimal tax policy suggests the commodities should be taxed according to the inverse elasticity rule. Goolsbee and Petrin (2004) find that the elasticity of demand for basic cable service is -0.51, and the demand for direct broadcast satellites is -7.40. Applying the inverse elasticity rule would imply that: (t BASIC /t SATELLITE )=(η SATELLITE BASIC )=(7.40/0.51)=14.5 Thus, tax rates on basic cable should be 14.5 times higher than tax rates on satellite television because basic cable is inelastically demanded, while demand for satellite television is highly elastic. Among the assumptions that go into the inverse elasticity rule are that goods are neither complements nor substitutes, and that the elasticities are the Hicksian compensated elasticities rather than the Marshallian uncompensated elasticities. In this case, it is likely that the first of these assumptions is false – basic cable and satellite television are likely substitutes for each other. The Hicksian and Marshallian demand elasticities are likely to be close to each other because the income effects are likely to be small for this commodity. 2. Luxury cars have a higher demand elasticity than basic transportation, so this tax would be less efficient (have a larger excess burden) compared, for example, to a tax on the first $10,000 of any car purchase. Although the tax schedule is progressive, the incidence is not clear at all. This is determined by the relative demand and supply elasticities for expensive cars. Administration of this tax would not be straightforward: One could imagine methods of evasion such as misrepresenting invoices or selling the car in parts!
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