# Consumption Tax

## Shift of the Tax Burden and Price Determination

We now investigate the effect of tax on consumption goods. When the government imposes a tax on a consumption good, how is the price and burden on the consumer affected? This depends upon how much the consumer price increases in response to the tax. The degree of incidence of the tax burden to consumers depends on economic conditions.

Using a partial equilibrium framework, let us examine the impact of imposing a tax on a particular consumption good. The partial equilibrium approach assumes that the effect of a tax does not spill over the economy, so that we may only consider the impact on a specific goods market.

In Fig. 8.7, the vertical axis is the market price of good P and the horizontal axis is the demand D and supply S of the good. The downward sloping curve D is the demand curve and the upward sloping curve S is the supply curve. The intersection of both curves determines the equilibrium in the good’s market. Without a consumption tax, the equilibrium point is E0 and the equilibrium price is P0,

The government now imposes a specific consumption tax. Namely, the firm has to pay a tax of T yen per quantity of product. This is called an ad valorem tax. Since the firm pays the tax to the tax authority, the firm is a legal taxpayer. Then, the supply cost of the product increases by T yen per unit and the supply curve moves upward by the amount of T yen. In this regard, the equilibrium point moves from E0 to Ej.

Let us compare equilibrium before and after the imposition of the tax. We denote by Pd the consumer price, which the consumer effectively pays, and by Ps the producer price, which the producer effectively receives. Before the imposition of the tax, the consumer price and the producer price are the same and equal to the equilibrium price, P0. After the tax, the consumer price rises to Pj and the producer price declines to Pj — T.

However, even if the producer is the legal taxpayer, the producer does not necessarily pay all the tax. Part of the tax is transferred to the consumer as an increase in the equilibrium price and a decrease in the producer price. As shown in

Fig. 8.7 The firm as the legal taxpayer

Fig. 8.7, it is rare that the market price increases by the same amount of the tax and the consumer pays all the tax. Such a 100 % incidence on the consumer is unlikely to occur. Later, we consider such extreme cases in Fig. 8.9. It is also rare that the market price does not increase at all. Such a 100 % incidence on the producer is unlikely to occur. The burden of tax is generally shared by the consumer and the producer, depending upon economic conditions.