Relevant Review:

   Key Concepts:

Excise tax; Price elasticity; Tax incidence

Congress recently approved a 15-cent increase in federal excise tax on a pack of cigarettes.  President Clinton has further proposed a rise of cigarette tax by as much as $1.50 over the next decade.  He claimed that raising cigarette prices is the best way to deter underage smoking.  How will such tax hikes affect cigarette sales and consumption?  Who actually will ultimately bear the tax burden?  In this Current Event Analysis, we will examine these two issues.

Background

Cigarettes are already a heavily taxed product.  Sales or excise taxes from both the federal and state governments account for over 25 percent of the product's retail price.  The reason why governments levy heavy taxes on cigarettes and other tobacco products is that these products produce medically harmful effects not only on users but also on nonusers through what is known as secondhand smoking.  Therefore, these products are regarded as socially undesirable. Public-health officials, however, remain unsatisfied with the slow decline in cigarette consumption, despite the high tax levels.  Cigarettes are an addictive product, meaning that smokers' current consumption depends on their past consumption.  In addition, as opposed to other products such as orange juice, cigarettes have few substitutes.  For these reasons, cigarette smokers are rather insensitive to increases in cigarette prices.

Tax Incidence
 

In Figure 1, we illustrate how an excise tax affects a market.  Before the imposition of the tax, the equilibrium price is $2.0, and the equilibrium quantity is 100 million units.  If a tax of $1.50 is imposed on each unit sold, what will be the effect on the price of the product?  Or to see it from the consumer's perspective, how much of the tax is passed on to the consumer in the form of a higher price?  The allocation of the tax burden between buyers and sellers is known as the tax incidence.

Since the tax is collected from the sellers, its effect on the market can be illustrated by an upward shift of the supply curve by the amount of the tax.  We show this in Figure 1.  Since the pretax price is $2.0 for sellers to supply 100 millions units of the good, the post-tax price has to be $1.50 higher, or $3.50, to induce the same level of supply.  The reason why sellers require $1.50 more to supply the pretax amount is that they must pay the tax of $1.50 to the government.

Who actually pays the tax?  Figure 1 shows that the equilibrium price after tax is $2.75, an increase of $.75 over its pretax level.  Clearly, in this case half of the tax is passed on to consumers, who pay $.75 more.  The reason why the new equilibrium price is $.75 but not $1.50 higher is that the quantity demanded dropped as a result of the tax imposition.  Since sellers now collect $2.75 but not $3.50, they end up absorbing the other half of the tax after paying the government the $1.50 tax. But it is not always true that sellers pass half of the tax on to consumers and swallowing the rest themselves.  The results actually depend on how buyers and sellers react to a change in the price of the good.  This concept is known as price elasticity.

Price Elasticity of Demand

Cigarettes are an additive product and have few substitutes.  For these reasons, the price elasticity of cigarette demand is very low, especially in the short run when smokers find is difficult to "kick the habit."  Both the Surgeon General and some economists have reported that a 10-percent increase in the price of cigarettes reduces consumption by only 4 percent in the short run.  In other words, the price elasticity of demand for cigarette is -0.4, meaning that cigarette demand is inelastic.  How does the nature of cigarette demand affect the distribution of tax burden between cigarette users and producers?
 
 

In Figure 2, we draw a demand curve for cigarettes, which is less elastic or less flat than the one shown in Figure 1.  The new diagram shows that the new equilibrium price for cigarettes after the imposition of an $1.50 excise tax is $3.0.  This means that the price increase is now $1.0 rather than $0.75 as shown in Figure 1.  This result arises because consumers are willing to pay more for cigarettes, so that the excise tax results in little reduction in the quantity demanded.  On the other hand, the amount that is absorbed by cigarette producers is now $.50, which is less than that in the former case.  By comparing Figures 1 and 2, we see that the less elastic is the demand for a good, the greater the rise in the equilibrium price.  As a result, the larger is the portion of the tax shifted to consumers and the smaller is the portion absorbed by producers.

Other factors, however, may also affect the tax incidence.  For example, in the long run, demand for cigarettes becomes more elastic when more time is allowed for smokers to quit smoking.  Therefore, we would expect the tax burden on consumers to become smaller.  In addition, we have so far learned about how demand elasticity affects the market price and tax incidence, holding the supply elasticity equal.  It can also easily be shown that the increase in market price is greater if the quantity supplied is more sensitive to price than it is less sensitive.

Review Questions

1. With the aid of a demand-supply diagram, illustrate the effects of an excise tax on a market?
2. How can the price elasticity of demand affect the distribution of tax burden between buyers and sellers?
3. How does the nature of cigarette demand affect cigarette users' tax burden?