Case Study Analysis: The Luxury Tax & Demand Elasticity | Microeconomics | Trường Đại học Quốc tế, Đại học Quốc gia Thành phố Hồ Chí Minh

Group assignment presentation 4: Case STUDY ANALYSIS
The Surprising Elasticity of Demand for Luxuries
As part of an overall package to reduce the US Budget deficit, the Congress
adopted a 10% 'luxury tax' on such big-ticket items as pleasure boats,
private airplanes, high-priced cars, jewelry... Such luxury taxes are often
popular because most people do not have to pay them. All taxes are painful
to someone, but surely a tax that weighs only on rich people who are buying
frivolous luxuries is one of the more socially painless ways to raise money.
However, the discussion of elasticity and inelasticity in this chapter should
make you suspicious of a key assumption underlying this tax. The
assumption was that the demand for these luxury goods was quite inelastic.
We can think of the luxury tax as increasing the total cost producers face in
bringing goods to market, so the supply curve effectively shifts up. Thus,
when the industry supply curve shifted up in response to the new luxury
tax, the equilibrium quantity would change little while the equilibrium price
would rise much, as the rich simply paid the extra cost.,
If the demand for these luxury goods was reasonably elastic, however, then
the upward shift in the supply curve would lead to a much smaller rise in
equilibrium price and a larger fall in equilibrium quantity. As it happened,
sale of pleasure boats fell by nearly 90% in South Florida, as prospective
buyers bought boats in the Bahamas to avoid paying the tax. Sales of high-
price cars like Mercedes and Lexus also fell substantially when their
customers moved to buy substitution products.
This unexpected elasticity of demand carried two bits of bad news for the
economy. First, rather than falling on the wealthy as had been hoped, the
burden of the new luxury tax actually ended up falling on the workers and
retailers who manufacture and sell these luxury items, many of whom are
middle class at best. Second, the luxury tax raised far less money than had
been expected. The Congressional Budget Office had forecast that the tax
would raise about $1.5 billion over five years. But in the first year, it raised
only about $ 20 million. Once the costs of setting up and enforcing the new
tax were considered, it probably lost money for the Government in its first year. Discussion Questions
1. How can you use the theory of "Supply, Demand - and elasticity " to explain the case (by using graphs)?
2. What is the implication for the Government in the tax policy? NGUYỄN HỒNG NGUYÊN KHANH
1. Case 1: the demand for luxury goods is inelastic Price s1 ($) s B P P A P D Q Q Quantity (units)
The gap between A and B is 10% tax.
As the supply curve shifted up,
P1 is the new equilibrium price and Q1 is the
new equilibrium quantity. Since the demand for these goods is inelastic, a
substantial rise in price only results in a smaller drop in quantity demanded. P P 1
E is the consumers’ tax incidence which is indeed higher than that of the producers’ ( P P 2
E ), indicating that consumers have to bear a higher
proportion of tax, leading to an increase in total revenue. In this way, the US budget deficit is reduced.
Case 2: the demand for luxury goods is elastic Price s1 ($) s P B P A P D Q Q Quantity (units)
As the supply curve shifted up,
P1 is the new equilibrium price and Q1 is the
new equilibrium quantity. Since the demand for these goods is elastic, a
slight increase in price would results in a significant drop in quantity demanded. P P 1
E is the consumers’ tax incidence which is indeed smaller
than that of the producers’ ( P P 2
E ), indicating that the tax would be
producers’ (workers, retailers, manufacturers) burden, leading to sharp drop
in total revenue. In this way, the US budget deficit is now even more severe. 2.
Since reasonable taxation is by far one of the most useful tools to alter both
supply and demand factors, the government would use all their authority to
balance the wages of the population. Sometimes, in order to address the
deficit, reducing taxes might be a viable measure because of its ability to
accelerate employment since business owners now can allocate more
money for hiring workers. Also, as the cost to launch a product is then lower,
enterprises would be able to produce more goods to hit the market with
better prices which stimulate customers’ will to spend their money.
Therefore, buyers would not have to look for alternatives. On the other
hand, with cases like the second one featuring products that are elastic, the
government would have to long for other solutions.