Question

The government of Markville started charging an excise tax on gasoline. After one year, it was found that gasoline demand was not different from that before the imposition. The governor of Markville argues that the excise tax has no burden because it showed no change in demand. She also argues that a gas tax can be a relatively efficient way to raise tax revenue. Evaluate her arguments. Note: Let X-axis denote gasoline, and Y-axis denote other goods.

1. Analyze the argument at an individual level. Draw an indifference curve and income line. Show how the demand was different before the imposition.

   a) Analyze the argument at a market level. Draw a supply and demand curve of gasoline. Feel free to attach your illustration. Show how the demand was not changed by the imposition.

b) What is the magnitude of the deadweight loss? What problems can we expect when the government increases the proportion of excise tax?

Answer 1

In the above diagram we have shown the change in demand of gasoline due to excise taxes, i.e, lower income.

As income falls to level 2, demand falls minutely to Q'.

From the problem, we know,due to imposition of excise tax, demand does not visibly change, this means that the demand curve is inelastic. Now, due to imposition of excise tax, supply curve shifts inwards as shown in the diagram below:

In the above diagram supply curve shifts to Supply^T due to excise tax. Although Quantity changes to Q'(very minute in change), price rises higher. The tax generated generates revenue to the government. Also there is some amount of dead weight loss (DWL) associated with the taxes.

i)Dead weight loss is small in this case.

ii)If government increases tax more, there will be a noticeable change in quantity demanded. Also, that will create a higher tax burden on consumers and producers.