Question

Consider the following quotation: “When a tax is levied on a good, a share of it is paid by both the consumer and producer. In the case of cigarettes however much more of the burden of the tax is paid by consumers, even though the tax is levied on the suppliers of cigarettes.”

Why might this be the case? In your answer explain both parts (sentences) of this statement. If the price of a packet of cigarettes increased by 10%, and in light of your explanation of the quotation, would you expect the quantity of cigarettes consumed to increase or decrease, and by more or less than 10%? Explain your answer.

Answer 1

Tax burden falls on both buyer and sellers and they are shared in the sense that taxes fall equivalently on buyers and sellers. This means due to taxes buyers pay higher prices than before and sellers receive less price than before. In this sense they share the tax burden. However the burden falls more heavily on that side where elasticity is less. Having less elasticity means that the agents respond less to a change in price. Cigarates are inelastic goods for the consumers because cigarette is addictive in nature. Chain smokers or people who smoke in general do not have any other alternatives to feed their addiction - when taxes raise the price of cigarates and so they continue to consume cigarates. This indicates low responsiveness of consumers. While supply in case of cigarettes is more elastic as sellers have other alternatives to producing cigarates. So buyers with a more inelastic demand than supply face a higher tax burden.

As explained cigarates have inelastic demand so the value of the elasticity for cigarette is less than 1. The formula for elasticity is given as

E = percentage change in Quantity/percentage change in price.

E<1 = percentage change in Q/ 10% increase

or, percentage change in Q = E<1 × 10%

As E is less than 1 the percentage change in quantity will be less than the percentage change in price. So for a rise of 10% price of cigarates, cigarette consumption decreases (from law of demand - price rise, quantity falls) by less than 10% because E is less than 1.