Excise Taxes and Changes in Consumer Surplus

© 1999-2020, Douglas A.Ruby (06-04-2020)

An Excise Tax is a per-unit tax placed on the sale of a good (usually goods rather than services). These taxes often are imposed to generate revenue for federal, state and local governments and sometimes take the place of a per-use fee as in the case of a gasoline tax used to pay for roads, bridges and infrastructure. Excise taxes are sometimes considered to be Sin taxes in that they raise the price of certain products (tobacco and alcohol) with the goal of deterring use.

We often model the imposition of such taxes on the supply-side of the market. This corresponds to the administrative ease in collecting tax revenue -- fewer business relative to the number of consumers and business firms tend to keep better accounts. When imposed (and for now assuming a perfectly-elastic or horizontal supply curve), the excise tax cuts into consumer surplus as the market price increase and consumer buy less of the product.

In the diagram below, move the Excise Tax slider to the right -- say a $10 exicse tax. Pay attention to the numbers in the status boxes. Notice that the supply curve S is modified to read S + T. The vertical distance is the amount of the exicse tax. Also note the change in Consumer Surplus. The initial value in the absence of the tax is $80,000 ($90 - $50) x (4,000 units). As a tax is imposed the value of consumer surplus decreases. Some of it goes to the government in the form of Tax revenue, specifically the amount of the tax multiplied by the new equilibrium quantity.

For example with an excise tax (T) of $10.00:

New equilibrium quantity: 3,000 units
New (remaining) Consumer Surplus: [($90 - $60) x 3,000]/2 = $45,000

The difference between the change in Consumer Surplus and tax revenue collected is known as the Deadweight Loss. In this example the difference is equal to $5,000.

Change in Consumer Surplus: $80,000 - $45,000 = $35,000
Tax Revenue collected: $10.00 x 3,000 units = $30,000
Difference or Deadweight Loss: $35,000 - $30,000 = $5,000

Deadweight loss is a meaure if inefficiency in resource allocation due to a distortion in the market -- in this case: imposing an excise tax. The need to generate government revenue comes with a cost in the form of lost consumer surplus that isn't recovered by any agent in the market-place

Demand Excise tax  

The relative steepness or flatness (more inelastic / more elastic) of the demand curve, affects the amount of revenue generated. Demand that is relatively elastic indicates that consumers have more substitutes avialable or that the good is a large part of their budget. These consumers are more price sensitive. You can model this my moving the Demand slider to the right. With increase price sensitivity, quantity demanded falls by a larger amoung with the imposition of the tax and thus the amount of tax revenue generated decreases. Markets where demand is relatively elastic are not good markets for using excise taxes for revenue porposes. Also, when demand is relatively more elastic, the deadweight loss is greater -- there is more distortion in the market.

When you move the Demand slider to the left, you will notice that the opposite is true. If demand is relatively inelastic, quantity demanded: a) falls by a smaller amount, b) the same tax generates more revenue and c) there is a smaller deadweight loss -- less distortion in resource allocation.

In the real world, you will find that excise taxes are often imposed on markets where consumers are less price sensitive like; tobacco, alcohol, telecommunications services, etc.

Concepts for Review:
Top of page related: Markets and Equilibrium previous: Consumer Surplus Next: Derived Demand Microeconomic Theory
© 1999-2020, Douglas A.Ruby (05-18-2020)