Question

Tom consumes, among other things, telephone services. He pays a fixed tax t on every phone call he makes (in addition to the regular price), and ends up paying $100 every year in telephone taxes. Show that Tom would actually prefer to pay flat tax of $100 and make phone calls taxfree. You should assume that Tom is rational, and that he has strictly convex and monotonic preferences over telephone calls and "other goods."

Answer 1

• Quantity Tax: A quantity tax of “t” will shift the original budget line AB in inward direction. The quantity tax will lead to new budget line, that is, AC. The consumption of telephone services has now reduced from T₀ to T₁. Tom will now have to pay tax on each of the call made by him.
• Lumpsum Tax: With a lumpsum tax of $100, the budget line will shift in parallel direction because it will reduce the consumption of both the telephone services as well as of other goods. The new budget line will be A’B’ as the income of Tom will decrease by $100. The new indifference curve is now tangent at point E₂ where the consumption of telephone services is T₂.
• Conclusion: It can be seen that the consumption of telephone service with lumpsum tax is greater than the consumption with imposition of quantity tax. Since, T₂ > T₁, so Tom will prefer a flat tax of $100.