We first consider a tax levied on buyers of a good. Suppose, for instance, that our local government passes a law requiring buyers of ice-cream cones to send $0.50 to the government for each ice-cream cone they buy. How does this law affect the buyers and sellers of ice cream? To answer this question, we can follow three steps. For analyzing supply and demand (1) We decide whether the law affects the supply curve or demand curve. (2) We decide which way the curve shifts. (3) We examine how the shift affects the equilibrium.
Price of ice cream cone without tax $ 3.00
Buyers’ Tax levied $ 0.50
Price sellers’ receive $ 2.80
Price buyers’ pay $ 3.30
The initial impact of the tax is on the demand for ice cream. The supply curve is not affected because, for any given price of ice cream, sellers have the same incentive to provide ice cream to the market. By contrast, buyers now have to pay a tax to the government (as well as the price to the sellers) whenever they buy ice cream. Thus, the tax shifts the demand curve for ice cream.
We next determine the direction of the shift. Because the tax on buyers makes buying ice cream less attractive, buyers demand smaller quantity of ice cream at every price..
We can, in this case, be precise about how much the curve shifts. Because of the $0.50 tax levied on buyers, the effective price to buyers is now $0.50 higher than the market price whatever the market price happens to be. For example, if the market price of a cone happened to be $2.00, the effective price to buyers would be $2.50. Because buyers look at their total cost including the tax, they demand a quantity of ice cream as if the market price were $0.50 higher than it actually is. In other words, to induce buyers to demand any given quantity, the market price must now be $0.50 lower to make up for the effect of the tax. Thus, the tax shifts the demand downward by the exact size of the tax ($0.50).
Having determined how the demand shifts, we can now see the effect of the tax by comparing the initial equilibrium and the new equilibrium. You can see that the equilibrium price of ice cream falls from $3.00 to $2.00 and the equilibrium quantity falls from 100 to 90 cones. Because sellers sell less and buyers buy less in the new equilibrium, the tax on ice cream reduces the size of the ice cream market.
Implications: We can now return to the question of tax incidence: Who pays the tax? Although buyers send the entire tax to the government buyers and sellers share the burden. Because the market price falls from $3.00 to $2.80 when the tax is introduced, sellers receive $0.20 less for each ice cream cone than they did without ($2.80) but the effectively including the tax rises from $3.00 before the tax to $3.30 with the tax ($2.80 + $0.50 = $3.30). Thus, the tax also makes buyers worse off.
To sum up, the analysis yields two lessons:
Taxes discourage market activity. When a good is taxed, the quantity of the good sold is smaller in the new equilibrium.
Buyers and sellers share the burden of taxes. In the new equilibrium, buyers pay more for the good, and sellers receive less.