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Difficulty: MediumIncidence and Effects of Taxation

The government levies a per-unit indirect tax on a manufactured commodity. If the coefficient of price elasticity of demand is 0.250.25 and the coefficient of price elasticity of supply is 1.251.25, which of the following statements correctly describes the incidence of the tax?

  1. Consumers bear a greater share of the tax burden than producers.Answer
  2. B
    Producers bear a greater share of the tax burden than consumers.
  3. C
    Producers bear the entire tax burden while consumers bear none.
  4. D
    The tax burden is shared equally between consumers and producers.

Answer

Consumers bear a greater share of the tax burden than producers.
Tax incidence depends on the relative elasticities of demand and supply. The share of an indirect tax borne by consumers is given by EsEd+Es\frac{E_s}{E_d + E_s}, while the producer share is EdEd+Es\frac{E_d}{E_d + E_s}. With Ed=0.25E_d = 0.25 and Es=1.25E_s = 1.25, consumers pay 1.251.50=83.3%\frac{1.25}{1.50} = 83.3\% of the tax, and producers absorb 16.7%16.7\%. Therefore, consumers bear a significantly greater share of the tax burden.

Step-by-Step Solution

1
Compare the relative magnitudes of price elasticity of demand (EdE_d) and price elasticity of supply (EsE_s).
Ed=0.25E_d = 0.25 and Es=1.25E_s = 1.25, which establishes that Ed<EsE_d < E_s.
Tax incidence is governed by the relative price elasticities of market demand and supply.
2
Calculate the proportion of the tax passed onto consumers.
Consumer share = EsEd+Es=1.250.25+1.25=1.251.50=56≈83.3%\frac{E_s}{E_d + E_s} = \frac{1.25}{0.25 + 1.25} = \frac{1.25}{1.50} = \frac{5}{6} \approx 83.3\%.
The consumer burden ratio is proportional to supply elasticity over total elasticity.
3
Calculate the proportion of the tax absorbed by producers.
Producer share = EdEd+Es=0.251.50=16≈16.7%\frac{E_d}{E_d + E_s} = \frac{0.25}{1.50} = \frac{1}{6} \approx 16.7\%.
The producer burden ratio is proportional to demand elasticity over total elasticity.
4
Determine which group bears the greater share.
Since 83.3%>16.7%83.3\% > 16.7\%, consumers bear the greater share of the tax burden.
The less elastic side of the market absorbs the larger share of an indirect tax.

Key Concept

Tax Incidence and Price Elasticity of Demand and Supply
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Topics

Incidence and Effects of Taxation

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