Price Elasticity of Demand Blog

Discussion on the excerpt from Microeconomics by Jeffrey Perloff, based on “Senate Panel Kills Tax on Luxury Items” (Los Angeles Times, 1992), “The Bottom Line” (New York, 1992), and “Taxes: Tempestin a Yacht Basin” (Time, 1991).

 The United States government’s impositions of new taxes always tend to be controversial issues both in the debates over their merits before passage and the examination of their efficacy down the road.  In 1990 the government enacted luxury taxes at values that it anticipated would increase tax revenues on yachts, planes, furs, jewelry, and cars.  However, due to the relatively low breakpoints for the onset of the 10% tax on these goods, it negatively affected demand to a significant enough degree to decrease net tax revenues for all of the goods except cars.  Since these industries produce goods that are almost exclusively at the high end of the overall price range, their sales are extremely price sensitive.  This exemplifies the classroom concept of price elasticity of demand; consumer demand for goods will shift more rapidly in highly elastic goods when their prices change.  These items tend not to be necessities, and many people in the market quickly become priced out of the desire to buy them, which is fitting with the items in Perloff’s article.

Considering the majority of yachts and aircraft cost more than their $100,000 and $250,000 respective onset amounts for the tax, the tax hit essentially every sale in these industries.  The yachting industry saw sales of yachts priced over $100,000 drop 71% in the first year of the tax, as people buying expensive yachts easily found a way to avoid the tax by acquiring boats outside the United States.  Employment in the industry dropped approximately 28% the first year, and the net tax loss from the pursuant decline in payroll taxes versus the minor increase in revenue from the luxury tax was $141 million.  Due to the negative impact of the luxury taxes in these highly price elastic industries, the tax was revoked in mid 1993 in order to avoid continued economic harm and the related losses in tax revenue.

 In the article, Perloff states that the purpose of the ad valorem tax was to raise tax revenue without hurting the lower and middle classes.  To this end, the tax was only placed on luxury goods.  However, the most effective way to raise revenue by taxing goods in general would be placing the tax on items for which demand is inelastic.  In this case consumers would continue to purchase the items, with much less of a regard for increases in price.  Such a tax would not completely erode domestic demand and would raise significant tax revenues.  This underlying concept for raising tax revenue is inconsistent with the United States’ decision to tax luxury items, since a price increase significantly reduced quantity demanded, and therefore tax revenue.  This also shows why the tax on automobiles was actually effective: automobiles are more of a necessity than planes, yachts, furs, or jewelry, so cars have a much more inelastic demand because they are the most typical and necessary mode of transportation.  The tax raised almost four times as much as expected on automobiles in the first year alone, at $98.4 million.  The relative inelasticity and inclination for consumers to rather commonly buy vehicles over $30,000 made the automobile tax a revenue winner.

 Furthermore, a current real world application of price elasticity of demand is how the extreme inelasticity in oil demand negates the more typical demand structures previously discussed.  Even with highly volatile oil prices driving changes in costs that get passed down to consumers at the bottom line, there are not drastic changes in demand for many products derived from oil.  The most obvious example is demand for gasoline, which has its price constantly fluctuating and can see swings over just weeks that constitute 20% changes in price at the pump.  The most prominent modes of transportation in the United States are completely dependent on gasoline or fuel, which is why price changes have relatively little effect on quantity demanded.  Both automobiles and airplanes warrant endless consumption that simply lacks any viable substitutes.  Much of the necessary travel is work related, but beyond that people also continuously use vehicles for the convenience factor that is still very difficult to price out.  Hence, consumers are forced to operate relatively unencumbered by price in the transportation sector because the costs passed down to them in gasoline and airline prices are effectively unavoidable.  In most industries, a 50% increase in price over a year or two would lead to drastic declines in sales.  However, when gas prices have shown such sustained jumps in the past, the declines have been much less pronounced due to consumers’ reliance on gasoline.  This perfectly exemplifies inelastic goods, which see demand schedules in stark contrast to the luxury goods that were being taxed in the early 1990s that Perloff discusses in his article.

 Posted by Mikelle, Michael and Joe (Section 1)

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