## Wednesday, December 23, 2009

### To Tax Tans or Not to Tax Tans, THAT is the Question!!

The issue of whether to tax elective cosmetic surgeries or tanning sessions raises the question of which one is more effective at (1) raising tax revenue, (2) inflicting the least amount of harm on the industry which ultimately may affect employment in that industry.  In Micoreconomics we look at something called elasticities. In this analysis we will examine the Elasticity of Demand for a good or service.  Elasticity in layman's terms is if a change in the price of a good/service changes quantity demanded of the good/service significantly then its demand is said to be relatively elastic. If the change is quantity demanded is less significant when the price changes then the demand is said to be relatively inelastic.  In other words, if quanitity demanded is very sensitive to changes in price then it is elastic. If quantity demanded is not very sensitive to changes in price then it is inelastic. GOT THAT?? I am going to intentionally avoid the math associated with this concept, for your sake.  Elasticities are actually very important when discussing tax policy.  I am going to use the Tan Tax as an example, but we can apply the same analysis if the tax was levied on the comestic surgery industry.

An economics lesson would not be complete unless you had a graph to go with it.  Below you will find a graph of the Market for Tans.  We have a market price of \$20 and a market equilibrium of 100 Tans (I am using very simplified numbers, but the concept will bear out regardless of the numbers).  This indicates that the quantity demanded EQUALS quantity supplied in this market m.  We are in equilibrium.  Our market supply curve is vertical at 100 Tans. This suggests the market (in the short run) has the capacity to provide 100 Tans REGARDLESS of the price (just take this as a given right now).

Notice the Demand curve (D*) is downward sloping and relatively flat. This represents a demand curve that is relatively elastic--small changes in price lead to large changes in quantity demanded. At a price of \$20 and a market quantity of 100 the Total Revenue in the industry is \$2,000.

The government now imposes a tax on Tans of 10%. Instead of costing \$20 per tan it now costs \$22. Lets see what this looks like on the graph.

At a price of \$22 the Quantity Demanded is now 40 Tans ("B") and the quantity supplied is still 100 Tans ("C").  In the market we now have a SURPLUS of 60 Tans (unused tanning beds).  Our market is in disequilibrium.  The Total Revenue now is \$880 (\$22 X 40 Tans, but \$80 of that is Tax Revenue). One of two things could happen.

The market supply curve could shift LEFT to 40 Tans.  There would be 60 less tans which means that the business would (1) reduce employees because of reduced demand, and/or (2) some will go out of business as the ripple effect would close some businesses "at the margin".  Either way, the employment in the industry going to DECREASE.  Tax revenue to the government would total \$80 (\$2 Tax X 40 Tans).

Lets assume that instead of decreasing the market supply, the tanning salons collectively keep the price at \$20 and the business absords the \$2 tax.

The price the industry receives AFTER paying the tax is \$18.  The total revenue is \$1,800 (\$18 X 100). This would maximixe the tax revenues for the government.  HOWEVER,  because each salon is now receiving \$18 per tan instead of \$20 then the question still becomes, how will the salons react to this lower revenue?  Some will have to layoff workers and some, again "at the margin" will go out of business and employment will DECREASE.  The market supply curve will shift to the left in the second scenario, but by how much? The bottom line in both scenarios we know the supply curve will shift left and that workers will lose jobs and entrepreneurs will lose financial capital.  The brightside (forgive the pun) of this is that there are now fewer artificial tans and statistically there will be fewer cases of skin problems or out right cancers. Essentially what the government has done is reduce what it has deemed a "negative externality" by imposing a tax to reduce the market quantity of a good/service that imposes costs on a third party--the healthcare system and insurance that the rest of us pay for.

Now lets look at this from a diferent perspective.  Lets assume the in the market for tans people are not so responsive to changes in price.  GOTTA have that glow!  If a change in price does not significantly change the the quantity demanded then demand is said to be INELASTIC.  If demand is inelastic the demand curve is going to have a steeper slope compared to the previous example.

Assume the same 10% tax on tans raises the price of tans to \$22.

At \$22 the quantity demanded is 80 tans and the quantity supplied is 100 Tans. We now have a SURPLUS of 20 Tans.  The same scenario will play out as in the first example.  The supply curve could shift to the left by 20 Tans OR the industry could absorb the tax and recieve \$18 instead of \$20 per tan.  In either case, the market quantity shrinks.

In sum:  How does this compare to the surplus when demand was relatively MORE elastic ?(60 tans vs. 20 tans). The tax revenue now is now \$160 (\$2 X 80 Tans). How does this compare to the tax revenue when demand was relatively MORE elastic? (\$80 vs. \$160)  How does employment compare when demand was relatively MORE elastic? (Intuition tells me more people are unemployed in the first case as opposed to the second)

Bottom line: If government is going to tax an industry, it appears that in order to raise the most tax revenue AND minimize the employment losses to an industry they should tax the one that is the MOST inelastic compared to another....This begs: