Placing a tax on a good, shifts the supply curve to the left. It leads to a fall in demand and higher price.
However, the impact of a tax depends on the elasticity of demand.
If demand is inelastic, a higher tax will cause only a small fall in demand. Most of the tax will be passed onto consumers. When demand is inelastic, governments will see a significant increase in their tax revenue.
Diagram of tax on inelastic demand
Consumer burden of tax rise
- The consumer burden of a tax rise, measure the extra amount consumers actually pay.
- In the above example, the specific tax is $6.
- The price rises from $10 to $14 so the consumer burden is $4 (x) 80. Total consumer burden is $320
Producer burden of tax rise
- The producer burden is the decline in revenue from the tax
- In the above example, producers used to receive $10, but now after the tax is paid, they are left with $8 per uni
- The total producer burden is $2 (x) 80) = $160
Tax revenue for government
The total tax revenue for the government is $6 x 80 = $480
Effect of Tax on Elastic Demand
If demand is elastic, then an increase in price will lead to a bigger percentage fall in demand.
- In this case, the producer burden is greater than the consumer burden
- The tax will be more effective in reducing demand, but less effective in raising revenue for the government
- The total tax revenue for the government is $6 x 50 = $300
Comparison of inelastic and elastic demand
Video of Elasticity