Question

A tax is not distortionary if it has no substitution effect on consumers’ behavior. Consider a tax imposed on a product with a vertical market demand. Is this tax distortionary or not? In a diagram, illustrate the pre-tax and post-tax optimal bundles of a consumer whose purchases are not affected by a tax-induced increase in the price of good X. Use this diagram to analyze whether the tax has a substitution effect on the consumer’s purchases of X or not. Discuss.

Answer 1

A taxis considered to be distortionary (for the consumer) when a levy of tax leads to a fall in the optimal quantity of the commodity.

Considering a commodity for which the demand curve is vertical (elasticity of demand is infinite in this case) and the supply curve is upward sloping. In this case, the introduction of a tax on the product will be borne entirely by the producer. The supply curve would shift leftwards by the amount of the tax, equilibrium price would increase but the equilibrium quantity remains the same.

Thus, the tax had no effect on the consumer's purchase of X.

Diagrammatically,

E is the initial equilibrium, with corresponding quantity Q and price P. After tax, the supply curve shifts to S', equilibrium shifts to E' and the price increases to P'.