Question

For the following statements, do you agree or disagree? Why?

a. Taxing for externalities causes distortions that always result in excess burdens.

b. It is possible for a distorting tax to improve economic welfare.

c. An optimal system of excise taxes would impose the heaviest taxes on those goods with relatively elastic demands.

Answer 1

(a) False

A tax is imposed to correct negative externalities, which result in firms producing too much of the good at too less rice, compared to efficient outcome, unless internalized. So, free market production in absence of the tax generates deadweight loss (excess burden) from existence of negative externality, which is reduced when the tax is imposed. So such a tax reduces or eliminates the excess burden.

(b) True

A tax to rectify negative externality will increase economic welfare by lowering or eliminating deadweight loss.

(c) False

Demand is relatively elastic when a given increase in price (from imposition of tax) will lead to a less-than proportionate fall in quantity demanded. So, low tax is imposed on relative elastic goods and heavier taxes are imposed on relatively inelastic goods.