Regulatory Nature of Taxes - Essay Example

BUSINESS ECONOMY How are the price, income, cross price elasti of demand, and the price elasti of supply, relevant to assessing the effectiveness of taxes for cutting the consumption of unhealthy goods? The Regulatory Nature of Sin Taxes The analytical use of supply and demand curves and their elasticities are important in determining the effects of taxes on the prices and the volume sales of products, specifically their bearing on the tax incidence, which in the field of economics is the analysis of the effect of a particular tax on the distribution of economic welfare. It is important for the government to know how high tax rates can go before the tax base starts to shrink and government revenues start to fall. There are several taxes imposed by the government, each of which affects the economics of the market in different ways. An excise tax is defined as a tax imposed on a specific amount per unit of product, and for this reason is sometimes also referred to as a specific tax (Keats & Young, 2005, p. 149). In contrast, there are ad valorem taxes such as sales taxes, which are imposed on the value or price of the product or service. Taxes imposed on “unhealthy” goods are also called “sin taxes.” They are usually state-sponsored taxes which legislators readily resort to at times when the government is seen to run a budget deficit and needs to raise funds. The taxpayers rarely protest any imposition or increase of sin taxes, for the reason that the tax is not imposed on the general public but only those who buy the product which is seen as harmful to them, anyway. Sin taxes may either be specific or ad valorem, and are generally imposed on cigarettes or tobacco, liquor, and gambling. (Investopedia, 2009) Price Elasticities and Taxes The price, income and cross-price elasticities of demand as well as the price elasticity of supply all bear on the effectivity of imposing sin taxes. Price elasticity measures changes in demand due to changes in prices of the good, income elasticity the changes in demand due to changes in the buyer’s income, and the cross-price elasticity of demand changes in demand for a good due to a percentage change in the price of a related good. On the other hand, the price elasticity of supply refers to the percentage change in the quantity supplied for a good given the percentage change of price for that same good. These four elasticities are important in the determination of the tax incidence, though those that bear most directly are the price elasticities of demand and supply. This is because different commodities have different responses to increase in prices, and government’s selection of which commodities to tax and how much to tax will determine government revenue. Rose (2003) observes that this was considered by Adam Smith in Wealth of Nations (1776), when he wrote that high taxes diminished consumption and sometimes encouraged smuggling, translating to foregone revenues for the government, for which he recommended the lowering of the tax. Ricardo (1821, in Rose, 2003) noted in his classical treatise Principles of Political Economy and Taxation, that taxing luxuries has more advantage than taxing necessaries, traits closely related to elasticities. He attributes these advantages to the fact that taxes on luxuries are paid from income, not productive capital, because people would rather give up their luxuries than purchase them from their capital. This implication may as well be attributed to sin taxes, because sensible persons would rather give up their vices to avoid the tax than disturb their savings. (This may not always be the case, though, for vices which have attained an “addictive” pull on their consumers, perpetuating their use.) According to Ramsey’s Inverse Elasticity Rule, the distortion created by a tax is inversely related to the commodity’s elasticity of demand. Thus, commodities whose demand is less sensitive to price may be taxed more heavily than those which are more price sensitive. Granted that the tax poses the possibility of being passed on or “shifted” to the customer, it is further observed that if the elasticity of demand is higher, the seller ought to bear the burden of the tax because of the difficulty of passing the cost of tax to price-sensitive customers. If, on the other hand, the elasticity of supply is higher, the tax burden should be shifted to the buyer because being more inelastic, the demand could tolerate more the pass-on cost of the tax without demand being subsequently diminished (Hamm, n.d). In effect, it means that as elasticity of demand increases relative to elasticity of supply, the supplier’s ability to pass on the tax weakens (Moszer, 1981). For income and cross-price elasticities of demand, the effects are indirect but not entirely insignificant. A high cross-price elasticity would mean that imposition of the tax could cause consumers to increase demand for other goods, which is successful in stifling demand for the unhealthy product but which may impact negatively on revenues to the government. On the other hand, income elasticity will come into play only if the total tax burden (not necessarily the sin tax alone) on business is high enough to negatively affect real wages to the consumers, in which case they will tend to reduce their purchases of luxuries and unhealthy goods and services. Illustration source: Riley, 2006 Conclusion The study of price elasticities of demand and supply and to what extent they determine tax incidence has guided the government in solving some practical problems. Randolph (2006) cites the example wherein the Unites States Social Security payroll taxes are half-paid by employees and the other half shouldered by the employer. Economists, however, have come to the conclusion that the employee actually bears the entire tax burden because the employer passes the tax to the customer in the form of lower wages. By such mechanism, Randolph concludes that the tax incidence falls on the employee. The main theory rests in the observation that the tax incidence depends not on where the revenue is collected, but on the price elasticities of demand and of supply (Randolph, 2006). Wise observance of this dynamic ensures stable tax revenues with increasing tax rates. [Word count = 1,000; title, question and references not included.] References Earl, P E and Wakeley, T. (2005) Business Economics: A Contemporary Approach, McGraw-Hill. Elasticity (n.d.) Accessed 19 November 2009 from http://www.csupomona.edu/~mrsafarzadeh/content_w4.htm Hamm, D B (n.d.) Elasticities of Demand and Supply. Principles of Microeconomics. Accessed 19 November 2009 from http://web.ovc.edu/dhamm/MIC_Elasticity.ppt Keat, P G & Young, P K Y (2005) Principles of Managerial Economics, First Edition. Pearson Prentice-Hall. Moszer, M (1981) A Comment on the Laffer Model. Cato Journal, vol. 1, no. 1, Spring 1981, pp. 23-44. Randolph, W C (2006) International Burdens of the Corporate Income Tax. Working Paper Series, Congressional Budget Office, Washington, D.C., August 2006 Riley, G (2006) AS Markets and Market Systems. Accessed 19 November 2009 from http://tutor2u.net/economics/revision-notes/as-markets-price-elasticity-of-demand.html Rose, M (2003) Elasticity and Its Expansion. Teacher’s Corner, Library of Economics and Liberty, 6 Jan 2003. Accessed 19 Nov 2009 from http://www.econlib.org/library/Columns/Teachers/elasticity.html Sin Tax (2009) Investopedia, a Forbes Digital Company. Accessed 19 November 2009 from http://www.investopedia.com/terms/s/sin_tax.asp Read More