Introduction of a Tax in the Market

Reflecting their need for public expenditure, governments impose taxes on the production or consumption or incomes (or on some or all of them) that prevail at a market equilibrium. A tax taken from consumers modifies their demand away from taxed goods and towards untaxed goods, a decision made entirely due to the tax. Therefore, their pre-tax, free-market choice gets distorted and a new post-tax choice emerges. A tax taken from producers or the factors of production—comprising investors, wage earners and owners of land—that go into making a product, modifies their decisions to produce and supply, and a different, post-tax supply will be established in the market. The relationship between the pre- and post-tax equilibria reflects how consumers, producers and owners of factors of production react to the tax. These reactions depend on various elasticities of substitution between products, and elasticities of factor substitution across various factors of production. The impact of moving the original to another equilibrium results in an ‘excess burden’ of tax reflecting the fact that some consumer satisfaction is lost forever as a result of the tax. Some taxes cause more excess burden than others. These matters are the subject of analysis in this chapter.