Question

1. Recently the governor of Vermont proposed that cigarette taxes in Vermont should be increased substantially, from 44 cents a pack to 66 cents a pack. He estimates that Vermont can raise $20 million in revenue from this tax hike. He also pointed out that the neighboring state of New Hampshire was considering an increase in cigarette taxes. (6 points)
   
   a. How can it be that an increase in cigarette taxes will increase tax revenue, because, after all, a higher tax will increase cigarette prices and thereby decrease the quantity demanded?
   
   b. If New Hampshire chooses not to increase cigarette taxes, is it likely that Vermont can still raise $20 million in tax revenue? Why or why not? Explain.

Answer 1

(a.) The goods which are relatively inelastic, increase in price will lead to increase in revenue. The elasticity of  cigarette is considered as relatively inelastic i.e less than 1. In such situation, increase in price will lead to increase in revenue.

Given the relatively inelastic demand for cigarette,  increase in cigarette taxes will increase tax revenue for Vermont.

(b.)  If New Hampshire chooses not to increase cigarette taxes, Vermont can still raise $20 million in tax revenue is depends on Whether consumers of Vermont have access to purchase cigarette from New Hampshire, as price of cigarette is now lower in New Hampshire.

If consumers of Vermont have access to purchase cigarette from New Hampshire, Vermont can Not raise $20 million in tax revenue.

On the other hand, if consumers of Vermont do not have access to purchase cigarette from New Hampshire,  Vermont can still raise $20 million in tax revenue.