Question

Imagine that the market for pencils is perfectly elastic at price of 10 dollars. Now the government decides to put a 60% value tax (ad valorem) tax on consumers.

What is the burden of this tax if Q_d=70-P. How is it calculated?

Explain why most taxes create an excess burden. How about lump-sum taxes?

Answer 1

Price p = $10

The demand function is given by Qd = 70- P = 70 - 10 = 60

Total value of consumption = 60 × 10 = $600

At the tax rate of 60%, ad valorem tax = 0.6 × 600 = $360

The ad valorem tax is calculated as a percentage of the value of the good consumed.

Most taxes create an excess burden since each additional unit of the good consumed has a percentage of it taken away in form of tax . In case of lump sum tax, the tax burden remains constant no matter what quantity of the good is consumed. Therefore, while the tax burden in an advalorem tax depends on the quantity consumed, it is fixed in case of lump sum taxes.