Question

With an excise tax of $.50 per six-pack of beer a student purchases 12 six-packs per month. If the government requires the students to pay $6.00 per month as lump sum tax instead of imposing excise tax, how will the student’s consumption pattern and welfare be affected? Using a graph to explain your answer.

Answer 1

Excise tax of $.5 was a specific tax which meant that tax liability depended on number of beer bottles consumed. This was done to correct negative externality of consumption as shown in figure below. Imposition of per unit tax will shift supply curve to left and aim at reducing quantity from Q* to Qtax hence discouraging student to smoke as price that he/she pays will go up from P* to Pc. It will also help to reduce welfare loss shown in figure. Per unit tax will reduce purchasing power and will also change relative price of good.

The student response depends on elasticity of demand. If student is addicted and smokes a lot of cigarettes then he/she will be benefited. If does not then demand will go down as demand will be elastic in this case.

However, lump sum tax will not impact cost curve or quantity traded because lump sum tax will only reduce consumers purchasing power and will not change the price of beer bottles.

Hence lump sum tax is preferred.