Excise Tax Incidence: Context Rich Problem

Rochelle Ruffer, Nazareth College
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This material is replicated on a number of sites as part of the SERC Pedagogic Service Project
Initial Publication Date: November 13, 2009

Summary

In this context rich problem, students must analyze a statement about the effects of an excise tax. They are given information about elasticity of demand and elasticity of supply and must determine the incidence of the tax on consumers and producers.

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Learning Goals

Students wil be able to apply the concepts of excise taxes, elasticity of demand, elasticity of supply and tax incidence in a real world setting.

Context for Use

This context rich problem can be used in intermediate microeconomics or public finance. It's possible to use it in principles of microeconomics, but it might be too difficult. Not all principles courses cover tax incidence to this degree and the problem might be more appropriate at the intermediate level. The problem takes between 20-30 minutes of class time for the students to provide a thoughtful response. Students need to understand the impact of excise taxes and the concept that the relatively less elastic side of the market bears the bigger burden of the tax. They also need to be able to interpret values of elasticity and translate that into how it would impact the market.It is probably best used in groups, but could be used outside of class.

Description and Teaching Materials


You are an economic advisor to the U.S. Government Accountability Office ( GAO) of the Federal Government. The GAO has been asked by President Obama to find ways to generate more government revenue. One proposal under consideration is to add an additional excise tax to bottles of wine. While the price of wine varies, the average price of a bottle of wine is $10. Approximately 10 million bottles of wine are sold in the U.S. each year. Wine is a normal good. The elasticity of demand for wine is -.8 and the elasticity of supply for wine (in the short-run) is .4, but 1.2 in the long run (over time). You colleague proposes the following, "let's generate a $2 per bottle excise tax on wine. This will cause the average price of wine to increase to $12 and generate approximately $20 million in government revenue." As economic advisor, your colleague asks you to proof the report and make any changes before handing it over to the President. Prepare a written response to your colleague commenting on his report. Provide a graph to help illustrate your points.

Context Rich Problem - Excise Tax on Wine (Microsoft Word 25kB Apr7 09)



Teaching Notes and Tips

This problem can be used in intermediate microeconomics or public finance. It uses information from a number of different concepts -- supply shifters/excise taxes and elasticity as well as determinants of elasticity. It is meant to follow discussion of demand and supply and excise tax problems, not to follow after perfect competition and long run equilibrium. To do that, more information would need to be included such as what type of industry (perfectly competitive/constant cost etc). With those concepts, the problem would be more appropriate at the intermediate microeconomics level.

Another source of confusion for students is the additional information provided (the good is a normal good). This information is not needed to "solve" the problem.

Assessment

The students should recognize that the price does not rise by the full amount of the tax and quantity does not stay constant. In the short run, we would expect the producers to bear the bigger burden of the tax since supply is relatively less elastic than demand. In the long run, we'd expect consumers to bear the bigger burden, but in either case, not the full amount of the tax.

References and Resources