Inelastic Demand and Taxes

Readers Question: I am a business student and I would like to know how does the concept of price elasticity of demand help the government when setting indirect taxes?

A tax shifts the supply curve to the left.

If demand is inelastic, then the tax will have the effect of raising the price significantly and reducing quantity only slightly. This will help to increase tax revenue for the government. Cigarettes tend to have inelastic demand; when the government increases tax, firms are usually able to pass the whole increase onto consumers.

If demand is elastic. It means consumers are more sensitive to changes in prices. Therefore, an increase in tax will cause a big fall in demand, and price will rise only slightly. Therefore, the increase in government tax revenue will be smaller.