Federal and state governments often seek to raise tax revenue by levying excise or sales taxes on specific products. What economic factors should be considered in determining the products that will raise the most tax revenue? Give examples of products

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in your answer.

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Answer 1

Government officials should consider taxing products for which the price elasticity of demand is inelastic. Liquor, gasoline, and cigarettes are examples of goods with inelastic demand on which tax increases are imposed to raise tax revenue. When a product has an inelastic demand, an increase in taxes will increase total spending on the product and hence the revenue collected by government. There will be a negative effect on the quantity consumed, and thus employment in the industry, but the employment effects will be less harmful than if the product taxed was elastic. Taxing a product for which the demand is relatively elastic is likely to reduce tax revenue from the product and reduce significantly employment in the industry. Such a situation arose in 1991 when the U.S. Congress imposed a luxury tax on yachts costing more than $100,000. Congress thought that the demand for yachts was relatively inelastic, but it proved to be more elastic than originally thought. Employment in the boating industry fell significantly and the tax produced minimal revenue for government.