Question

Suppose that the average household in a state consumes 1000 gallons of gasoline per year. A 20-cent gasoline tax is introduced, coupled with a $160 annual tax rebate per household. Will the household be better or worse off under the new program? Graphically show how you arrived at your answer

Answer 1

If the household does not change its consumption of gasoline, it will be unaffected by the tax-rebate program, because the household pays ($0.20)(1000) $200 in taxes and receives $160 as an annual tax rebate. The two effects cancel each other out upto $160 and household will pay $40 extra. However, the utility maximization model predicts that the household will not continue to purchase 1000 gallons of gasoline but rather will reduce its gasoline consumption because of the substitution effect. As a result, it will be better off after the tax and rebate program.

The diagram shows this situation. The original budget line is AD, and the household maximizes its utility at point F where the budget line is tangent to indifference curve U1. At F, the household consumes 1000 gallons of gasoline and OG of other goods. The 20-cent increase in price brought about by the tax pivots the budget line to AB . Then the $160 rebate shifts the budget line out in a parallel fashion to EC where the household is again able to purchase its original bundle of goods containing 1000 gallons of gasoline. However, the new budget line intersects indifference curve U1 and is not tangent to it. Therefore, point F cannot be the new utility maximizing bundle of goods. The new budget line is tangent to a higher indifference curve, U2 at point G. Point G is therefore the new utility maximizing bundle, and the household consumes less gasoline and is better off because it is on a higher indifference curve.