Question

Government made proposal to increase the tax on gasoline by 50¢ per gallon.

The government would give poor consumers an amount of cash large enough that they could buy their original bundle (of gasoline and other goods).

1. Show how a typical poor person's budget line changes as a result of the tax and the subsidy.

2. Use a graph to show how the tax and subsidy could affect this person's optimal bundle.

3. Is this individual better or worse off or stay on the same bundle as a result of the tax and the subsidy? Explain your answer using your graph and show the possible scenarios.

Answer 1

After putting a tax on gasoline the poor's consumption position shifts to position 2 where his consumption capacity in Q2. Now with the tax, there is a subsidy for poor so now there is a parallel shift in budget line as there is a cash payment by the government. so the consumption of gasoline will increase to Q3 and but it is less than the original one but at the same time the poor will increase its consumption of other goods from q1 to q2. so this concept says that when we get a subsidy in terms of cash it will not only increase the consumption of the concern good also increase the consumption of other goods from the bundle.

2. Refer to figure B if we will analysis after-tax the consumption bundle of a poor comes down as gasoline is an inelastic consumable good. so to compensate that he will change his consumption pattern and consume less gasoline but to compensate the price he will also consume fewer other goods say it will change from q1 to q2where the consumption of gasoline will be Q1 to Q2.

When there is a subsidy in terms of cash the consumer will feel more relaxed and he will definitely increase his gasoline consumption which is not equal to the Q1 it will be Q3 and also other goods consumption will be increased from q2 t q3. Here the noticeable change is the other goods consumption increased as there is a cash subsidy.

3. Herewith tax and subsidy will present two types of effect on the poor's economic condition

a) Refer to figure A, if the subsidy or the cash amount will be less then the poor will feel worse off. as his consumption was before tax Q1 of gasoline it will be Q2 after-tax where in case of subsidy which is less then the tax will only somewhat reduce the burden of gasoline but overall, the poor will feel worse off.

b) In the case of figure B where the subsidy is more than the tax then the poor will feel better off and will increase his consumption of gasoline from Q2 to Q3 also increase his consumption of other goods from q2 to q3, which is greater than the initial consumption of other goods.