Question

Suppose you are working as a consultant to the U.S. Congress on the development of tax policy. You have been asked to estimate the cost to consumers of an increase in the federal gasoline tax, but the only information available to you in market demand information. Can you use this information to make a reasonably accurate estimate of the cost? If so, how? If not, why not?

Answer 1

Any tax on a product impacts both demand and supply.

It doesn't matter who pays the tax initially, because the final incidence of tax depends on the relative elasticities of demand and supply.

- If demand is more elastic than supply, producers will bear the burden.

- If demand is less elastic than supply, consumers will bear the burden.

Thus, if we have only market demand information about gasoline, it will give us only half the picture. With market demand information, we can further calculate elasticity, and the possible impact on revenues. However, we won't be able to calculate the impact on the suppliers of gasoline.

The burden on buyers (or sellers) represents the cost of the tax. To get a complete picture of the burden, both demand and supply data is required.

- For example, it is quite possible that if demand is inelastic, consumers will readily pay the higher price after the tax. But due to the higher price, sellers may decide to supply more gasoline. This may actually bring prices down.

- If demand is more elastic than supply, the government's tax policy may fail to generate revenue. Consumers may shift to substitutes.

Hence, only demand side information will not lead to an accurate estimate of the effects. For complete accuracy, both demand and supply side information is preferable.