4.

How Taxes and Subsidies

Affect Prices and Quantities

“The art of taxation consists in so plucking the goose as to obtain the largest amount of
feathers with the least possible amount of hissing.”

J.B. Colbert, circa 1683

(The quotation from Colbert captures the essence of Okun’s [1975] argument that we
will read later in the semester.)

This class deals with the effects that taxes (and subsidies) have on prices and

quantities. The issues are important because the public sector depends on taxes for the

revenues to purchase services such as public school education. Consequently, it is

important to understand how particular taxes influence the prices consumers pay, output

levels (and consequently, employment levels), and tax revenues raised. We will focus

particularly on the consequences of the imposition of sales taxes on a particular service,

rental of hotel rooms, in part because they are common taxes imposed by local

governments and states, and in part because the consequences of such taxes are somewhat

easier to show than the consequences of other types of taxes.

Think about the issue of taxes from the perspective of the mayor of a middle-sized

city. She may wish to support the school superintendent’s desire for additional funds for

the public schools, but she is also very concerned about the possible impacts that new

taxes might have on the unemployment rate of local residents (unemployed people tend to

vote against the incumbent), and on the prices paid by local residents (her constituency)

for goods and services.

One of the mayor’s advisors suggests a $10 per night, per room, tax on hotel

rooms. Arguments in support of this tax are that it will generate $5 million per year in

revenue (since the city has averaged 500,000 hotel rooms in use in each of the last few

years), that the tax will be borne almost entirely by visitors (who do not vote), and that it
4.2 How Taxes and Subsidies Affect Prices and Quantities

will have virtually no impact on employment since the city’s many hotels have been quite

full. Analyze the impact of the tax, both in the short run and the long run, on revenue

raised, on number of hotel rooms in use per year (which is a measure of employment), and

on the price of a hotel room.

Assume initially that the hotel market in the town is in equilibrium with 500,000

rooms in use per year, at a price of $100 per room per night. Further assume that the

supply of hotel rooms, QS, (in both the short run and the long run) is as follows:

QS = 2,500 PS + 250,000,

where PS is the price per room that hotel owners receive.

Assume that the short run demand for hotel rooms is as follows:

QDSR = 600,000 - 1,000PD,

where PD is the price that hotel guests pay,

and that the long run demand is as follows:

QDLR = 900,000 - 4,000PD.

To verify that the initial equilibrium price = 100, set QS = QDSR or QS = QDLR, and solve for P.

Notice that in the absence of a tax, PS = PD.

Then verify that the equilibrium quantity is 500,000, by substituting P = 100 into

the QS function, the QDSR function, or the QDLR function.

Now consider the effect of the tax in the short run. One immediate effect is that

the price owners receive, PS, is going to be $10 less than the amount that the consumers

pay, PD. In other words, PS = PD - 10.

Substitute this expression, PD – 10, into the supply function.1

QS = 2,500(PD - 10) + 250,000

QS = 2,500PD + 225,000

1
Another way to think about the effect of the tax here is that the total “cash” (PS) that the owner, when all is
said and done, will get to keep from any transaction is $10 less than whatever amount of cash that the
consumer will have to pay out of her pocket. That is, there is a $10 difference between the “gross” amount
paid by consumers (that appears as their total on the hotel receipt) and the “net” amount that the owners get to
keep. What is more, by algebraic manipulation, we see that PD = PS + 10. This is an alternate way of
expressing the PS = PD – 10 equation; by saying that PD = PS + 10, we are simply saying that the full price that
the consumer has to pay includes the amount seller will get to keep (PS) plus $10.
How Taxes and Subsidies Affect Quantities and Prices 4.3

Now set QS = QD, and solve for PD, PS, and Q (in the short run).

2,500 PD + 225,000 = 600,000 - 1,000PD

PD = 107.14

PS = PD - 10

PS = 97.14

QS = 2,500(97.14) + 250,000

= 492,850

In other words, the effect of the tax in the short run was to increase the price

consumers paid by $7.14. Since the tax totalled $10, consumers bore 71 percent of the

“burden of the tax,” or 71 percent of the “incidence of the tax.” The number of hotel rooms

used declined by 7,150, or 1.4 percent.

One might ask why consumers did not bear the full burden of the tax in the short

run. The reason is that competition among hotel owners to fill their empty rooms led

Figure 1. The Short-Run Effect of the $10 Hotel Tax.

Price
QS
($)

P D =107.14
C
100 A
P S=97.14
B

Q D SR

493 500
Quantity of Hotel Rooms
4.4 How Taxes and Subsidies Affect Prices and Quantities

gthem to reduce the price slightly. As a result, their net revenue per room fell to $97.14, or

$2.86 less than the amount received before the tax was introduced. Thus, in the short run,

the suppliers bore 29 percent of the “burden of the tax” (2.86/10.00).

Also, notice that even in the short run the tax proceeds were not quite the

anticipated $5 million, a projection based on the assumption of no decline in the number of

hotel rooms rented. In the short run, the annual proceeds from the tax amounted to $4.93

million. Figure 1 displays the pre-tax equilibrium values of P and Q, and the post-tax short

run equilibrium values of PD, PS, Q, and the amount of tax revenue collected.

One important point to notice is that the impacts of the tax on the equilibrium

prices (PS and PD) and quantity were derived without knowing whether it was the buyers

or the sellers who were legally liable for the tax. In fact, this is always the case: The legal

incidence of the tax does not influence the actual incidence in perfectly competitive

markets. In this case, the actual incidence was that 29 percent of the tax was borne by the

sellers and 71 percent of the tax was borne by the consumers. The actual incidence of the

tax depends on the elasticities of demand and supply (as reflected in the shapes of the

demand and supply curves), not on the legal incidence.

To this point, we have focused on the short run effects of the tax. The long run

effects are likely to be somewhat different because both demand functions and supply

functions tend to be more elastic in the long run than in the short run. The reason is that

both consumers and providers have more time to adjust. To keep the algebra simple, we

assume that there is no change in the supply function, and focus on the effects of having

the long run demand function be more elastic than the short run demand function. The

reason that the long run demand is more sensitive to price than the short run demand is

that consumers have more time to seek out alternative sites for vacations that would avoid

the $7.14 price increase resulting from the tax. Also, organizations booking convention

space may have commitments to the hotels in the short run, but they can seek other sites

for subsequent conventions.

Following the same methods used to calculate the short run effects of the tax, we

can show that in the long run the price consumers pay will be $103.85, implying that they
How Taxes and Subsidies Affect Quantities and Prices 4.5

Figure 2. The Long-Run Effect of the $10 Hotel Tax.

Price
QS
($)

P D =103.85
C
100 A
P S=93.85
B

Q D LR

484 500
Quantity of Hotel Rooms

bear 39 percent of the burden of the tax. The price suppliers receive falls to $93.85, and

they bear 61 percent of the tax. The number of hotel rooms rented per year falls to 484,615,

a reduction of 3.1 percent from the number rented before the tax. If employment is

proportional to output, this implies that local employment in the hotel industry fell by 3.1

percent as a result of the tax. Total revenue per year from the tax will be $4.84 million.

These long run effects are displayed in Figure 2. The rectangle BCGF depicts the tax

revenue. Note that if we had assumed that the long run supply curve was more elastic

than the short run supply curve, the reductions in the number of hotel rooms rented and

in local employment in the hotel industry would have been greater. Can you explain why

the long-run supply would be more elastic than the short-run supply?

In fact, experimentation with the curves in Figure 1 and Figure 2 will show that,

holding the demand function constant, the more sensitive the quantity supplied is to price

(i.e., the higher the supply elasticity), the larger the portion of the tax that will be borne by

consumers and the larger will be the decrease in the equilibrium quantity (and

consequently the larger will be the decrease in the number of people employed in the
4.6 How Taxes and Subsidies Affect Prices and Quantities

industry). There is an implication here for tax policy. When the policy goal is to raise tax

revenue, imposing a tax on goods for which the supply elasticity is very high is not

effective policy because such a tax raises consumer prices, reduces employment, and does

not raise much tax revenue.

Experimentation with the graphs will also show you that, holding the supply

function constant, the more elastic the demand function is, the smaller the proportion of

the tax that will be borne by consumers and the larger will be the reduction in the

equilibrium quantity. Thus, imposing taxes on commodities, such as alcohol sold in

Massachusetts, that have many substitutes, such as alcohol purchased in New Hampshire,

is likely to have significant employment effects on the Massachusetts retail alcohol

business. The same can be said about New Jersey’s tax on heavy trucks (see the N.Y. Times

article at the end of the notes for this class).

✎ Come to class prepared to explain why the New Jersey tax was
ineffective and whether a national tax on heavy trucks would have had
different consequences.

Also read the N.Y. Times article on the consequences of differences in

the alcohol taxing policies of England and France.

In addition, come prepared to discuss the Business Week article by Gary

Becker on the consequences of the proposed increase in the cigarette tax.
Using the information in the Becker article, calculate the short-run own-
price elasticity of demand for cigarettes. What is the long-run own-price
elasticity? Would a tax increase that raised the price of cigarettes by 25
cents result in an increase or a decrease in the total amount of money
consumers spend on cigarettes? Why? How would cigarette
manufacturers react to a government policy requiring that they raise the
price of a pack of cigarettes from the current level of about $2.25 to a
minimum of $3.00? Calculate the long run percentage reduction that this
price increase would have on the number of cigarettes purchased.
How Taxes and Subsidies Affect Quantities and Prices 4.7

The important lesson for tax policy is that if the goal of the tax is to raise revenue

and to minimize the reduction in output and employment brought about by the tax, then

the tax should be imposed on goods for which the demand is very price inelastic; in which

case the price paid by consumers will rise, but output will not fall very much. Or the tax

should be imposed on goods for which the supply is very price inelastic, in which case the

price consumers pay will not rise very much, and output will not fall very much. (The

price firms receive will fall by almost the amount of the tax.)

The difficulty in implementing this policy is that, while the short run elasticities of

demand and supply may be quite low for certain goods, long run elasticities are typically

much higher because consumers find substitutes and so do producers. Nonetheless, the

lesson does have some implications. For example, sales taxes imposed by municipalities

are likely to bring about greater reductions in output than are sales taxes imposed by

states. One reason is that, with municipal taxes, consumers need only drive to the next

town to make their purchases and avoid the tax. With state taxes, the drive is longer and

many consumers won’t bother. Also, firms can avoid the sales taxes by relocating in the

next town. The bigger the geographical area covered by the tax, the longer the move that

firms must undertake to avoid the tax. Similarly, a state imposed hotel tax is less likely to

result in a large employment loss than a local hotel tax.

Thus, there are many reasons why local citizens should be cautious in their

assessment of local taxes. First, writing the tax law in a manner that states that producing

firms rather than consumers are legally responsible for the tax does not mean that the tax

will not affect the prices consumers pay. Second, in the long run, firm relocation and

subsequent loss of employment may be a consequence of the imposition of local taxes.

These arguments do not mean that taxes are necessarily a bad idea. In fact, taxes to

pay for good schools may attract industry, increase employment, and raise property

values. The point here is that taxes imposed by higher levels of government, especially

the federal government, may result in less loss of employment than local taxes would. In

fact, this is one of the main arguments that motivated the federal revenue sharing

program, under which federal tax revenues were distributed to state and local
4.8 How Taxes and Subsidies Affect Prices and Quantities

governments. (This program was introduced under the Nixon administration and ended

under the Reagan administration.)

In a book published in 1992, economist Alice Rivlin has suggested that the federal

government institute a nationwide value-added tax (VAT) (which is similar to a national

sales tax) and distribute all of the proceeds to states on a per capita basis. Two arguments

underlie this proposal. First, the VAT is seen as replacing state sales taxes. Since the

national VAT would have a uniform rate, it would eliminate the employment losses

incurred by states with higher sales taxes than neighboring states. Second, the tax would

redistribute revenues from wealthier states to poorer states, thereby facilitating

equalization in the quality of public services, including education, provided by states.

(The reason the tax and distribution plan is progressive is that wealthier states would

contribute more VAT revenues than they would receive back, and the opposite would be

true for poorer states.

For an interesting discussion of the justification of providing firms with tax

incentives to locate within a specific geographic jurisdiction (for example, Boeing moving

its headquarters to Chicago), see Edward Glaeser’s comments in Gale and Pack (eds.),

Brookings-Wharton papers on Urban Affairs 2002.

In the November 2006 elections, the voters in eight states voted to raise the

minimum wage in their states. Now, more than 20 states have minimum wages above the

federal minimum wage of $5.15. Given this situation, does it make sense to leave

minimum wage policies to states?

Tuition Tax Credits for Private Schools

Periodically, governments (including that of the United States) debate the virtues

of passing tuition tax credit legislation, under which families could deduct a specific

amount, say $75, from their income tax liability, for each child that attends a private

school. Among the questions that arise in these debates are:

1. What will the tuition tax credit cost the government in terms of lost tax

revenue?
How Taxes and Subsidies Affect Quantities and Prices 4.9

Figure 3. The Geometry of Tuition Tax Credits:

Perfectly Elastic Supply.

V
P1 S
C T
D2
D1

O Q1 Q2
1. Case of perfectly elastic supply. Tuition (P1) does not change. Number of
children attending private schools increases from Q to Q2.
OQ2VP1= Total tuition revenue to private schools
OQ2TC= Net tuition paid by families after tax rebate
CTVP1= Total value of income taxes rebated to families. This is the loss in
tax revenue from the tax credit.

2. How will tuition tax credits affect the number of children attending private

schools?

3. How will tuition tax credits affect the prices of private schools?

These questions can be analyzed using the tools developed to analyze the

consequences of sales taxes (such as the tax on hotel rooms). The reason is that a tuition

tax credit of $75 can be viewed as a negative sales tax of $75. This negative tax creates a

$75 differential between the tuition that private schools receive from parents and the

ultimate price, after the tax credit, that consumers pay.

As we know from the tax incidence example, the effect of tuition tax credits

depends on the elasticity of demand for private schooling and on the elasticity of supply.

Only if supply is perfectly elastic (as illustrated in Figure 3) will the credit have no upward

effect on price and, consequently, will save families $75 per child attending private school.
4.10 How Taxes and Subsidies Affect Prices and Quantities

To get a better sense of the answers to the three questions listed above concerning

the consequences of the introduction of a tuition tax credit, try to work out answers to the

questions below before coming to class. (Question 3 is difficult!)

In Nebula, a poor developing country, the only secondary schools are private. All
private schools are of equal quality. Due to competition among them all schools
currently charge the same tuition of $500 per year. Currently 10,000 students attend
secondary school. The families of all students pay the $500 tuition level. A new
government has come to power with a commitment to expand access to secondary
school. One proposal is to offer all families an income tax credit of $75 for every child
that completes a year of secondary school. The proposal is that the tax credit would be
refundable. Assume initially that the introduction of the tuition tax credit has no
impact on the tuition at private secondary schools and that every family can find
secondary schools to send their children to.

1. Assume for the parts to this question that the own price elasticity of demand
for secondary schools in Nebula is zero. Under this assumption,

a. How will the tuition tax credit plan affect the number of students
attending secondary school in Nebula?

b. Under this assumption about the own price elasticity of demand, what
will be the annual cost to the government of the tuition tax credit
program?

2. Assume for the parts to this question that the own price elasticity of demand
for secondary schools in Nebula is –1.20. Under this assumption:

a. How will the tuition tax credit plan affect the number of students
attending secondary school in Nebula?

b. Under this assumption about the own price elasticity of demand, what
will be the annual cost to the government of the tuition tax credit
program?

3. Assume for the parts to this question that the demand for secondary schools in
Nebula can be described by the following equation:

QD = 20,000 – 20PN, where

QD is the number of students whose families want to send them to school and are
willing to pay a net price of PN to do so. Net price is defined as the tuition
How Taxes and Subsidies Affect Quantities and Prices 4.11

secondary schools receive from families minus the income tax credit.

a. Once families have adjusted to the tuition tax credit program,

the government finds that 10,500 students are now attending
secondary school. From this information calculate the net
price families pay to send a child to secondary school.

b. What is the gross price (PG) that families pay to send a child
to secondary school, where gross price is defined as the
tuition level that the secondary school receives?

c. Draw a supply and demand diagram that is consistent with

the information conveyed in this set of questions (parts of
question 3). The relevant information includes the demand
equation, the values of QD associated with different prices,
and the values of PG and PN. Label the values of QD, PG, and
PN on your diagram. State the numerical values of each.

d. Write out an equation that describes the relationship

between
quantity supplied (QS) and gross price (PG) Explain how you
derived the equation. (You should assume that the supply
equation is linear.)

I will put the answers to the above questions on the course website after we discuss them

in class.

An infinite elasticity of supply in the short run would mean that existing private

schools could expand enrollments markedly without experiencing increased costs. This

seems highly unlikely. An infinite elasticity in the long run means that new schools

would spring up, or existing schools would expand, to meet increased demand without

upward pressure on tuitions. Again, this seems unlikely. In fact, many Catholic school

educators have lobbied for tuition tax credits because they hope that credits would enable

fiscally stressed Catholic schools to remain open. However, the main mechanism through

which Catholic schools would benefit from tuition tax credits is by higher tuition. This is

not consistent with the assumption of infinite elasticity of demand.

4.12 How Taxes and Subsidies Affect Prices and Quantities

In fact, little is known about the elasticities of demand and supply for private

schools. Moreover, the relevant elasticities may differ markedly among the different types

of private schools. For example, supply may be quite elastic among Christian

fundamentalist schools. Supply may be quite inelastic at elite private schools such as

Andover and Choate. The logic to the hypothesis about low elasticity is that these schools

may respond to a higher price not by admitting more students, but by being more

selective among applicants. This situation is depicted in Figure 4. In this case, the credits

result in a significant increase in price, perhaps $150, thereby leaving the net price families

pay only $50 lower than the price before the credits were introduced. Also, in this case,

tuition tax credits resulted in only a small increase in the number of students attending

private schools.

One other issue that is critical to understanding the consequences of tax credits for

expenditures on particular goods (whether they be private schooling or health insurance)

is whether the tax credit is “refundable.” This provision concerns families with such low

Figure 4. The Geometry of Tuition Tax Credits:

Upward-Sloping Supply.

S
V
P2
P1 T
C D2
D1

O Q1 Q2
1. Case of upward sloping supply. Tuition increases after tax credit is introduced
from P1 to P2. P2 - P1 < size of tax credit.
OQ2VP2= Total tuition revenue to private schools.
OQ2TC= Net tuition paid by families after tax rebate.
CTVP2= Total value of income taxes related to families. This is the loss in
tax revenue from the tax credit.
How Taxes and Subsidies Affect Quantities and Prices 4.13

income that they pay no taxes. In the case of a refundable credit, a family with no tax

liability that sent a child to private school would receive a check from the government

equal to the value of the tax credit. If the credit were not refundable, poor families that

sent their children to private schools would receive no benefits. Thus, the issue of

refundability is critical to understanding the impact of a tax credit on the welfare of poor

families.

On June 27, 2002, the U.S. Supreme Court ruled that the voucher program in

operation in Cleveland Ohio does not violate the U.S. Constitution.

(See http://edweek.org/context/topics/issuespage.cfm?id=30 for details on the decision.)

There are many questions that need to be answered to understand how any particular

voucher program will impact on the number of students attending non-public schools in

the U.S. and on what the characteristics of attending students will be.

✎ Consider the simplest of cases in which a state passes legislation

that provides every child in the state with a voucher that is worth $3,000
toward the cost of a year’s education at a non-public school. Further
assume that non-public schools can set their tuitions and may accept
whatever children they choose. Further assume that prior to the passage of
the voucher legislation the market for private schooling in the state was in
equilibrium with all private schools charging $4,000, and 100,000 of the
state’s one million school-aged children attending private schools.

Draw a demand and supply diagram illustrating the equilibrium in the

private school market in the state before the passage of the voucher
legislation.

Explain how the passage of the voucher legislation will impact on the
curves in the supply and/or demand diagram. How will the passage of the
legislation impact on the number of students in the state attending private
schools? How will the passage of the legislation impact on the equilibrium
price of a year of private schooling in the state?
4.14 How Taxes and Subsidies Affect Prices and Quantities

References

Kirby, Sheila Nataraj and Linda Darling-Hammond. “Parental Schooling Choice: A

Case Study of Minnesota,” Journal of Policy Analysis and Management, 7(Spring 1988)3:
pp. 506-517.

Glaeser, Edward. “Comments” in Williams Gale and Janet Pack (eds), Brookings-
Wharton papers on Urban Affairs 2002, Washington, D.C.: Brookings, 2002.

Rivlin, Alice M. Revising the American Dream, Washington, D.C.: Brookings, 1992.
How Taxes and Subsidies Affect Quantities and Prices 4.15

August 17, 1990

Section B; Page 1

New Jersey May Scrap Tax on Trucks as Sales Plunge.

By Joseph F. Sullivan

Gov. Jim Florio, who has thus far resisted pressure to

change any part of his $2.8 billion tax program, is
prepared to rescind the sales tax on heavy trucks if the
Legislature can find other sources for the $44 million in
revenue that the tax was expected to produce,
administration officials and legislative leaders say.

The state sales tax was increased to 7 percent from 6

and several exemptions - including one for heavy trucks and
parts -were eliminated as part of the Governor’s tax
program approved by the Legislature in June.

But instead of beginning to raise $44 million, all the

sales tax on heavy trucks has done, industry spokesmen
contend, is to chase business to adjacent states like New
York and Pennsylvania, which do not tax heavy-truck sales.

The dealers’ complaints come amid taxpayer attacks

across the state on the Governor’s sweeping tax program. In
a television address Wednesday night, the Governor pleaded
for time to see if his changes will produce more revenue and
make the tax system more equitable.

Shortly before the Legislature passed the tax package in

June, trucking industry spokesmen warned that it would
produce little revenue and force truck dealers from the
state. Several lawmakers said they were convinced that the
industry’s arguments were valid, but no action was taken
for fear it would open the door to demands for last-minute
changes from other interest groups.

Drastic Drop in Sales

Charles E. Walton, president of the New Jersey Automobile

4.16 How Taxes and Subsidies Affect Prices and Quantities

Dealers Association, said that in the six weeks

since the state began taxing sales of trucks weighing
18,000 pounds and more, millions of dollars in truck sales
had been lost, along with the tax revenue the Governor was
looking for to help balance the state budget.

Mr. Walton estimated that at least 65 percent of

heavy-truck sales would move from New Jersey to other
states in the year starting July 1. In the previous year
trucks sales in the state came to about $328 million, he
said.

At a meeting in Edison on July 24, more than two dozen

of the state’s 50 heavy-truck dealers reported that they
had sold only 12 trucks in the three weeks since the sales
tax was extended to their industry, compared with 702 in
the same period in 1989, Mr. Walton said.

‘‘This has the makings of a disaster,’’ he said. ‘‘There

isn’t going to be much here in the way of truck and parts
sales. In addition, the truckers will simply set up small
terminals across the borders in Delaware, Pennsylvania or
New York, and the state will lose registration fees, which
range from $600 to $800 a truck.’’

If new trucks are registered in New Jersey, the owners

must pay the sales tax at that time, no matter where they
bought the vehicles.

Michael Porcelli, the head of Porcelli GMC Trucks Inc.

in Elizabeth, said he had lost a deal for 80 heavy tractors
worth $4.5 million to a Syracuse dealer when the buyer
decided he did not want to pay $300,000 in New Jersey sales
taxes.

‘‘That tax has got everybody scared,’’ Mr. Porcelli

said. ‘‘It won’t affect the sales of one or two trucks, but
when the deal is for 40 trucks, the buyer starts to figure
up that 7 percent tax.’’

He said parts dealers in Pennsylvania, which still

exempts heavy trucks from its sales tax, had already begun
aggressively seeking new business in New Jersey.
How Taxes and Subsidies Affect Quantities and Prices 4.17

Exemption Spurred Sales

In 1977, New Jersey was the first state in the Northeast

to exempt heavy trucks from the sales tax, Mr. Walton said,
and in the four years it took for Pennsylvania, New York
and most of New England to follow suit, the state’s
trucking industry boomed.

‘‘We became the trucking hub for New York and Long
Island,’’ he said.

The only Northeast state that did not exempt heavy

trucks from its sales tax was Connecticut, and the number
of heavy-truck dealers in that state has dropped to seven
from 42 in the last decade, Mr. Walton said. ‘‘If we don’t
restore our exemption, we’ll go the way of Connecticut,’’
he said.

Paul McMillan, executive vice president of the

Pennsylvania Automotive Association, said New Jersey’s tax
change was an immediate topic of conversation in
Harrisburg. ‘‘We’re so accustomed to seeing Pennsylvania
adopt changes that chase business,’’ he said, ‘‘it was nice
to see someone else shoot themselves in the foot for a
change.’’

Norma Sharp, director of the New York State Automobile

Dealers Association, said she felt sorry for New Jersey but
was thankful that in the pressure of adopting its own
budget, the New York Legislature left in place the sales-tax
exemption for heavy trucks. ‘‘That’s one of the few things
they didn’t tax, thank goodness,’’ she said.
4.18 How Taxes and Subsidies Affect Prices and Quantities

July 28, 1993

Section C; Page 8

Wine Talk.

By Frank J. Prial

CALAIS, France. IT was just after 5 A.M. when Simon Judd

sped along a darkened road in England, hurrying to Dover, where
he planned to catch the 6 A.M. cross-channel ferry that would
bring him to this French port.

Mr. Judd was not alone; not in his car, and not on the
roads of southern England leading toward the channel ports
and the breaking dawn. He and his family, along with
hundreds of other Britons, had forsaken their beds that
morning and were heading for France. And bargains.

For the Judds and shoppers all over Western Europe, a

single market became a reality last Jan. 1. Import barriers
on hundreds of products disappeared while unequal tax
barriers remained. The result: wonderful cross-border price
disparities for dedicated bargain hunters.

By noon, the Judds had parked their station wagon in the

lot of a Mammouth supermarket in a shopping center just
south of Calais, 10 minutes from the ferry terminal where
they had disembarked two hours earlier.

By 1 P.M., Mr. Judd and Brian Cooke, his son-in-law, had

loaded the trunk and back seat of their car with 40 cases
of beer, each containing 25 small 25-centiliter bottles. An
average American beer can holds 33 centiliters. There were
also bottles of wine and some cordials and whiskies.

At home, the Judds and other British shoppers may buy

warm Watneys, but here in Calais, they load up on
Kronenbourg from Alsace, Holsten from Germany, Stella
Artois from Belgium and even Budweiser from the United
States. So much for brand loyalty.
How Taxes and Subsidies Affect Quantities and Prices 4.19

“We figure we save anywhere from 40 to 60 percent over

English prices,” Mr. Judd said, looking with satisfaction
at his overloaded car. “And now we’re off for a good French
picnic.”

The Judds had paid L15, about $25, for their round-trip
ferry voyage. The fare is usually closer to $100 but they
were taking advantage of a newspaper subscription
promotion. “Take the paper for the week and get a cheap
fare to France,” Mr. Judd said.

There was time for a picnic because the Judds had no

long line at customs to face on the return trip. They could
bring back whatever and as much as they chose. Indeed,
there were dozens of large vans in the Mammouth lot, all
with British license plates and all being loaded with beer,
wine, spirits, cigarettes -- and an occasional loaf of
French bread.

A case of 25 Kronenbourg splits (about 9 ounces each)

costs $7.50 here in Calais. The equivalent would be $23 in
London. But then beer sold in London carries an excise tax
of about 50 cents a pint; here in France the tax is about
two and a half cents. A carton of Marlboro cigarettes, $35
in Britain, is $20 here.

The wine and beer section at Mammouth is large, but

then, so is the store. The French call these immense places
hypermarkets.

Mammouth’s beer business is so brisk that management has

broken through a rear wall and erected a large tent to hold
only cases of beer. It is not unusual to see a British
couple struggling with a chain of five food carts filled
with beer.

The wine selection -- after all, this is France -- is

large and varied. But this is no connoisseur’s heaven. Most
so-called bargains are in anonymous wines from the south of
France.

On the day the Judds shopped here, Mammouth was offering

a nondescript rose from somewhere in the south of France
for $1.30. A red table wine from the Herault, also in the
4.20 How Taxes and Subsidies Affect Prices and Quantities

south, called Domaine des Felines, was moving briskly at

$1.10. A commercial Cotes du Rhone from the Burgundy
shipper Moillard was $3, not much less than it would cost
in London.

British shoppers buying wine concentrated on low-end

products, most of them in the $2 to $5 category. An
assistant manager said specials like the $1.30 rose are
particularly popular with British customers.

There are some fine wines, but they seem to be ignored

by the mostly blue-collar customers from across the
channel. A Chateau Lynch-Bages 1987 -- not a great vintage
-- was about $39; a Chateau Pichon Baron from 1985, a much
better year, was $57, and a Chateau Ducru-Beaucaillou from
1982, another good year, was $52. No bargains here, by
English, American or French standards. One bargain that
seemed to have few takers: a 1990 chardonnay from Wente
Brothers, in California, for $6.75.

British brewers are urging their Government to reduce

excise taxes on beer, which is the best bargain and the
favorite purchase among British shoppers here. Their
Government’s response has been to urge France to raise its
excise taxes, a step the French have no desire to take.

Denmark, faced with a similar exodus due to the new

single-market changes, has reacted, lowering its excise
taxes to bring back shoppers who were driving across the
border to Germany to buy their Carlsberg.
How Taxes and Subsidies Affect Quantities and Prices 4.21

August 15, 1994

Copyright 1994 McGraw-Hill, Inc.

Warning: A Higher Cigarette Tax May Be

Hazardous to Health Financing

By Gary S. Becker

08/15/1994

Some members of Congress advocate a massive federal tax

hike on cigarettes to help defray the costs of a
health-care bill. The medical profession and other
opponents of smoking agree on a large tax increase, though
their goal is not to raise revenue but to cut down smoking.
Recent research, however, indicates that a sizable cigarette
tax would not generate much tax revenue, although it would
cut smoking by a lot.

These findings appear in the June issue of The American

Economic Review, in an article by Michael Grossman, Kevin
M. Murphy, and me. In it, we estimate the response of
cigarette smoking in the U.S. to changes in retail price,
income level, and other variables. The research can be used
to obtain reliable calculations of the effects of increases
in the federal cigarette excise tax on government revenue.

These calculations assume that each 25 cents increase in

the tax raises retail prices by the same amount--even
though various studies indicate that prices may rise by a
little more than the tax increase. Higher retail prices
reduce smoking mainly by discouraging some people from
beginning and by encouraging others to quit earlier than
they otherwise would have, although higher prices also
reduce the number of packs smoked by those who continue to
smoke. Teenage smoking is especially sensitive to the cost
of cigarettes.

Initially, a higher price for a pack of cigarettes does not

4.22 How Taxes and Subsidies Affect Prices and Quantities

cut smoking by a lot, since many smokers cannot quickly

break the habit. But the impact is cumulative as each
reduction in smoking further weakens the habit and
encourages additional reductions. Indeed, our article
estimates that the impact of a rise in price is about twice
as large after the price has been in effect for a year:
After one year, a 10% increase in price cuts smoking by
about 4%, but after three years the reduction doubles to
about 8%.

HOOKED POLITICIANS.

The present 24 cents federal

tax on a pack of cigarettes yields about $6 billion
annually in federal revenue. The estimates of demand in our
article imply that to reach maximum revenue in the long run
would require a tax revenue of about 95 cents a pack and
would raise only $6 billion annually more than the present
tax. Note that somewhat larger tax revenues would be raised
during the years it takes smokers to fully adjust to the
higher price.

This estimate of tax revenue is much lower than that of the

Congressional Budget Office because, in sharp contrast to
our estimate of an 8% reduction in smoking per 10% increase
in price, the CBO assumes that smoking falls at a constant
rate, by about 4% for each 10% increase in the cost of a
pack.

Some members of Congress are proposing a still larger

increase of $1 a pack to raise the total federal tax to
$1.24. That tax, in the long run, would raise only $9
billion in annual revenue--a mere $3 billion more than at
present--but would cut smoking by more than 70%. Tax
revenue rises and smoking falls as the total federal tax is
increased to 95 cents, according to our estimates, but both
smoking and tax revenue fall as the tax is made larger.

The conflict between tax revenue and consumption reduction

may seriously affect government policies toward smoking. If
the feds get hooked on the revenue generated by smoking
taxes, Congress may hesitate to impose severe regulatory
restrictions on smoking. State lotteries provide a telling
warning of how this pressure works: Despite the still
How Taxes and Subsidies Affect Quantities and Prices 4.23

considerable moral and other opposition to gambling and

even though lotteries are actuarially very bad bets, many
states advertise extensively to the poor and others to
encourage the purchase of lottery tickets.

BOOTLEGGERS’S BOOTY.

Smuggling of cigarettes from neighbor nations would

reduce still further the federal revenue generated by a tax
hike. Canada recently was forced to reduce its draconian
$2.69-per-pack cigarette tax by $1.82 because of massive
smuggling from the U.S. A large U.S. tax hike would spur
smuggling from Mexico and other Latin American nations with
much lower taxes and would illegally divert some cigarettes
meant for export to domestic use.

Cigarette taxes fall largely on the poor, since the

heaviest smokers are in the lowest income and education
brackets. Some smokers would be discouraged from starting
if the cost of a pack rose from $1.80 to $2.80 with a
$1-per-pack tax increase. But those who couldn’t break the
habit and continued to smoke, say, 11/2 packs a day would
pay $1,533 a year in cigarette taxes, a large amount for
people on welfare and those with modest incomes. It makes
little sense to help finance the increased cost of the
President’s health plan partly with a tax that falls mainly
on the poor and less educated--groups that are supposed to
be helped by his health reforms.

The case for much higher cigarette taxes is very shaky in

light of the regressive nature of the tax, the limited
amount of revenue that would be generated, the
encouragement of cross-border smuggling, and the temptation
that it would pose to the federal government to encourage
smoking in order to raise tax revenue.
4.24 How Taxes and Subsidies Affect Prices and Quantities

Optional Appendix: Alternate Representations of the Effect of a Tax

In this set of class notes, we have used diagrammatic as well as algebraic

representations of the effects of a tax. Earlier, in Figures 1 and 2, the effects on QD and QS

are shown before and after the imposition of a tax. However, these diagrams depict the

effect of a tax without showing a shift in either the demand curve or the supply curve.

Instead, the diagrams show how the price consumers pay (PD) and the price that sellers

actually receive (PS) are driven apart by the imposition of the tax. Though perhaps less

intuitively appealing, it is possible to represent the post-tax change in the effective prices

for consumer and seller by showing either a shift in the demand curve or a shift in the

supply curve. That is, we can also think about the effective prices, PS and PD, as resulting

from either an upward shift in the supply curve (see Figure 5) or a downward shift in the

short-run demand curve (see Figure 6).

Why would either of these representations work equally well? Because both

scenarios can be shown to incorporate the effects of the $10 relative difference occasioned by

the tax.

If we assume that the tax shifts the supply curve upward at all points by $10,

this is the same as saying that after the tax is imposed, sellers will desire $10 more than

they used to collect in order to “remain whole.” The price sellers get to keep is now $10

less than the amount that buyers will actually pay. After the tax, sellers will be willing to

supply fewer hotel rooms at every price because they are now effectively required to remit

to the government $10 from every sale. When the “take” for sellers feels as if its only

$97.14, then they will only be willing to sell 493 rooms.

If we assume, instead, that the tax shifts the demand curve downward at all

points by $10, this would specify that after the tax is imposed, buyers will want to pay $10

less, the relative price they faced before the tax was imposed. Buyers now have to pony

up $10 more than sellers will actually keep. After the tax, buyers will purchase fewer

hotel rooms at every price because they are now effectively required to give $10 to the

government at each sale. When the full price felt by the consumer goes up to $107.14, they

will only be willing to purchase 493 rooms.

How Taxes and Subsidies Affect Quantities and Prices 4.25

Figure 5. The Effect of a $10 Tax Represented as

an Upward Shift in the Supply Curve.

Supply curve
shifts upward QS 2
Price by $10 QS 1
($)
C
PD=107.14
100
PS=97.14
B
QDSR

493 500
Quantity of Hotel Rooms

Figure 6. Effect of a $10 Tax Represented as a

Downward Shift in the Demand Curve.

Demand curve
shifts downward
Price by $10 QS
($)

PD=107.14
C
100 A
PS=97.14
B

QDSR 1

QDSR 2

493 500
Quantity of Hotel Rooms
4.26 How Taxes and Subsidies Affect Prices and Quantities

It may still not be obvious why the effect of a tax can be represented equally

well, with the same mathematical results, whether you choose to shift supply upward or

demand downward. You can think of these two alternate representations as two sides of

the same coin. For simplicity, you can imagine that, if you choose to shift the supply curve

upward, you are assuming that the seller is the person who actually has to remit the tax to

the government and therefore directly responds to the “pinch.” Likewise, if you choose to

shift the demand curve downward, you are assuming that the buyer is the person who

remits the tax to the government and therefore directly responds. In either case, we arrive

at the same post-tax equilibrium quantity (in our example, 493 rooms). However we

choose to depict the response to the tax, the ultimate market result is the same. In either

case, the new equilibrium and the relative burden of the tax for buyer and seller are

products of the interaction between the supply and demand curves.