Tax Incidence and elasticity

In this exercise students will critically analyze elasticity impacts on tax incidence.

This activity is appropriate for principles of microeconomics classes as well as survey of economics classes of any size. Students should have an understanding of price elasticity of demand, price elasticity of supply and tax incidence. The activity will use approximately 15 minutes of class time. The activity is not connected to other activities in the AE library.

Overview

This exercise asks student teams to identify the best of five items to tax for the purposes of raising tax revenues for their school. This is accomplished via the process of several analysis steps. In the first step teams place products into order from most price sensitive to least price sensitive to a hypothetical 10% tax. Discussions around ranking will focus on the determinants of elasticity, as well as the supply and demand model. The second step asks student teams to create general graph analyses of a tax applied to the items ranked as most elastic and least elastic. Students should also consider the goals of the tax are three-fold: 1. To minimize inefficiency, 2. To maximize revenue collection, and 3. To take into account the tax impact on poor households. In the last step student teams will identify the selected item and note the key points to explain their reasoning from team discussions in steps one and two. This exercise should follow general instruction covering elasticity or public choice theory.

The application can easily be modified to require students to present the technical analysis and reasoning to defend their answers.

Expected Student Learning Outcomes

In this exercise students will critically analyze elasticity impacts on tax incidence.

Information Given to Students

Scenario: Your local community has decided to offer greater financial support to your school by applying a 10% tax to a good or service sold in the community. Tax revenues will be given to the school for the purposes of decreasing tuition costs and other forms of student support. Assume that even online purchases can be tracked to the location where ordered and the tax would be applied to online orders placed while in the community. Your team, given your background in economics and involvement in the school as students, has been selected to identify the good or service best suited for this task from a list of preliminary approved items. The choice made by your team should have the best chance of maximizing revenue generation for the school.

Three concepts from your principles of economics course will help you with this analysis: elasticity, the supply and demand model, and tax incidence. Your team will analyze the items in two stages utilizing these concepts in order to identify the best taxation choice.

The first stage of analysis for your team is to analyze and rank the tax-considered items in terms of price elasticity of demand, by first identifying the most elastic item and least elastic item, then determining the rank of the remaining items in between. Be ready to defend your choice of ranking through use and analysis of elasticity determinants.

List the below items in order of most elastic to least elastic:
Salt
Marijuana
Soft drinks
Music subscriptions
Cigarettes

#1 most elastic =

Elasticity determinants explaining reasoning:

#2 =

Elasticity determinants explaining reasoning:

#3 =

Elasticity determinants explaining reasoning:

#4 =

Elasticity determinants explaining reasoning:

#5 least elastic =

Elasticity determinants explaining reasoning:

Stage two of your analysis begins once you have ranked your items according to elasticity. In this stage, create a general supply and demand graph analysis representing the tax incidence for the two items identified as "most elastic" and "least elastic" in stage one. Note: reviewing class instructional materials on the supply and demand model and the steps for analyzing tax incidence using supply and demand is recommended. (A general discussion and summary within the team of the impacts of elasticity on tax incidence is encouraged before application of the concepts to this exercise) Students should include in their notes for this AE the Supply and Demand analysis of tax incidence in the presence of both elastic and inelastic demands.

Use your understanding of tax incidence and graph analysis to consider which of the two items is most likely to meet the goals of 1. maximum taxation revenue for the school, 2. least inefficiency; and 3. take into account the tax impact on poor households. Once analyzed, state the product or service recommended for taxation.

In stage three of your analysis your team will discuss and identify the item selected for taxation and state the supporting points from your analysis in stage one and two to "make your case" for it best meeting the goals of 1. maximum taxation revenue for the school, 2. least inefficiency; and 3. take into account the tax impact on poor households.

Product or service recommended for taxation: ________________________________

Key points of analyses:

Your rankings and choice showcase your understanding and ability to utilize the determinants of price elasticity of demand, tax incidence, and the supply and demand model. Be ready to explain your reasoning based on these economic concepts.

Student Handout Tax Incidence and Elasticity (Microsoft Word 2007 (.docx) 7kB May4 20)

See Teaching Notes and Tips for the mechanics of this activity.

Student handouts are included and linked with this exercise with instructions as outlined in the Instructions Given to Students and Teaching Notes and Tips sections. The time requirement for this exercise is 90 minutes and should be used to solidify understanding of elasticity and tax incidence.

This activity requires students to think critically about elasticity impact on tax incidence, therefore this AE should follow instruction in these concepts. A brief review of how to analyze taxes in the supply and demand framework, along with defining and identifying tax incidence, is recommended. Also, an emphasis on the three goals of the exercise (1. To minimize inefficiency, 2. To maximize revenue collection, and 3. To take into account the tax impact on poor households) can be verbally emphasized and electronically communicated via document projection or written notes on the front board of the classroom.

The first step by teams is to rank the five items according to elasticity - this will require students to critically analyze the determinants impacting elasticity for each market. Encourage student teams to refer to a list of determinants and discuss the relative impacts of each determinant on each item. Another suggestion is to encourage students to think about which items buyers would be "most likely to walk away from" if price were increased vs. "least likely to walk away from". Then, identify and discuss why the team members feel this way via the determinants of elasticity.

Once ranked from most to least elastic, have student teams create supply and demand graph representation of applying the tax. Remind students of the general shape of fairly elastic vs. fairly inelastic (less elastic) demand and supply curves. The instructor will likely need to float around the class helping teams remember that a steep demand curve means a less elastic demand, all else equal. Student teams may need to be reminded of the steps for identifying tax incidence by consumers and producers as well as efficiency loss. Encourage discussion of whether producers or consumers should bear the burden of the tax, as well as, comparisons of efficiency loss between the two items selected.

The first two steps of the AE help to ensure student teams can critically analyze elasticity determinants to items, and can apply this understanding to graph analysis.

The last step of the AE has students select their best choice item and reflect on their reasoning via guidance from notes taken in steps one and two Instructors are encouraged to wrap up this last step with a team discussion of elasticity of determinants and final elasticity graph analysis review. This review could expand the discussion to multi-stage reporting by first asking the class what they predict will be the most elastic demand item reported by team (suggestion use online polling), the least elastic demand item selected by teams, and to predict the item most commonly chosen by teams to tax. Then, have teams report their selected most elastic, least elastic and selected items. Discussion may be extended to compare and contrast differences or confirmations between predictions and what was selected and reasons why.

Class discussion should include a comparison of items selected for taxation, reasons for selection, and possible economic impact of selections.

Closing Remarks: Instructors are encouraged to close with a brief review of the determinants of the elasticity of demand: availability of substitutes, expenditure share of the item, viewpoint as a luxury or necessity, and time. (For more advanced classes, a discussion of elasticity of supply determinants may also be included.) Also, a final review of the supply and demand analysis of taxes will probably be useful for most students. Finally, the instructor should point out that the inefficiency created by taxes on goods and services should be weighed against the economic surplus created by government provision of the good or service funded by the taxes.

Essay questions:
What type of product or service would be most likely to raise tax revenue if applied by government?

What characteristics of a good or service should be identified by government, in order to best increase tax revenues?