Question

What is the 'excess burden' of a commodity tax. Explain why optimal tax theory suggests that lump sum income taxes should be used rather than commodity taxes in order to raise revenue.

Answer 1

Commodity tax refer to tax on transactional value of the commodities. Transactional value refers to either purchase or sales value of commodities like gold, silver, sugar, soya oil, wheat, rice, etc. Commodity tax or Commodity Transaction tax normally refers in context with trading of commodities through exchanges. Example of Commodity tax can be like 0.01% of transactional value for every transaction above 10 million.

Excess burden refers deadweight loss i.e., change in consumption of a person due to tax. Since commodity tax depends on elasticities of demand and supply for a commodity. Since its not pre-defined who pays the tax and write the check to government are two different persons. Tax on supply increases the price of that commodity by the amount of the taxes which reduces the demand since now the buyers have to pay more by the tax amount. As shown in below figure, since new euilibruim shift from E to E', the buyers pays more still the sellers receives less, which is known as dead-weight loss or excess burden.

On the other hand, lumpsum tax is regressive tax means same amount of tax irrespective of income of the person. Example - professional tax of $200 is charged to every CPA professional irresyive of how much a CPA professional earn.

Optimal theory refers to systematic allocation of tax to reduce distortions like excess burden. Commodity tax say on food articles are paid by everyone including poor people thereby increasing tax burden on poor people compared to rich people.

Though both the taxes increases tax burden still lumpsum tax does not affect the relative price of the commodity. In other words, after lumpsum tax, people are free to spend their income wherever they like, creating on pressure on them to substitute one commodity with another due to relative prices.