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 of producers face in bringing a 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 reasonable elastic, however, then the upward shift in the supply curve would lead to a much smaller rise in equilibrium price and a lager 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. Sale of high- priced 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 implication for the Government in the tax policy ?