Question

9. Consider a case where the government decides to increase taxes on cigarettes. Assume a shape of the supply and demand curves for cigarettes. Given your curves, how does the increase in tax change the amount of government tax revenue? Explain in words and graphically.

Answer 1

Demand for cigarettes is inelastic because cigarettes are an addictive good and taxes are mainly passed to consumers in form of higher prices.

Therefore, assumption is demand curve is inelastic and supply curve is normal upward sloping.

When the government decides to increase taxes on cigarettes , this will increase the amount of government revenue.

From the figure , we can see that , that initial the demand curve is D . After the imposition of tax , demand curve shifts to the left and it is D1. And the price consumer pay P1 and sellers receive P' and the tax amount is BC. And government revenue = P1BCP'.

When government increases the tax on cigarettes ,then demand curve shifts to the left to D2. As a result , the price consumers pay = P2 and price sellers receive = P0 . Tax amount = EH. Government revenue = P2EHP0.

It implies that as a result of increase in tax on cigarettes , government tax revenue would increase.