Excise Tax

What is Excise Tax?

Excise tax refers to a tax on the sale of an individual unit of a good or service. The vast majority of tax revenue in the United States is generated from excise taxes.

Excise taxes are generally applied to correct the negative externalities generated by the consumption of a unit of the good or service. For example, there are excise taxes levied against gasoline and cigarettes.

How Excise Tax Affects the Quantity and Price of Goods or Services

Assuming that Good A is a homogenous good, in the absence of taxation, the equilibrium price is P₀, and the equilibrium quantity is Q₀. If the government decides to impose an excise tax of $X, the owners of Good A will only supply the quantity demanded at a price of P₁ + $X.

After taxation, it can be observed that the quantity demand changes from Q₀ to Q₁, as the equilibrium moves from B to A. It implies that the application of taxation will lead to a decrease in quantity demanded. Excise taxes lead to either consumers paying more or producers receiving less.

Excise Tax Imposed on Consumers

If excise tax is imposed on consumers, the consumer’s demand for Good A will decrease. It is illustrated as the demand curve shifts from position D₀ to D₁. Quantity shifts from Q₀ to Q₁ after the excise tax has been imposed on consumers of each unit of Good A.

The difference between P₂ and P₁ is the amount of excise tax that is imposed. It is also the amount the demand curve shifts from D₀ to D₁.

Excise Tax Imposed on Producers

If excise tax is imposed on the producer, the supplier will provide less quantity of Good A. It is illustrated as the supply curve shifts from S₀ to S₁. Quantity shifts from Q₀ to Q₁ after the excise tax is imposed on the production of Good A.

The difference between P₂ and P₁ is the amount of excise tax that is imposed. It is also the amount the supply curve shifts from S₀ to S₁.  The area falling under the demand curve and above the supply curve between Q₁ and Q₀ is considered the deadweight loss of tax. It is a loss of surplus.

What is the Incidence of Excise Tax?

The incidence of excise tax is the measure of how much of the tax the producer and consumer are responsible for. It is important to note that it often does not matter who officially pays the tax, as the equilibrium outcome is the same.

Incidence of excise tax generally falls unevenly between consumers and producers, as one group bears more of the tax burden than the other. The primary factor in the incidence of excise tax is the price elasticity of supply and the price elasticity of demand.

Excise Tax Paid Mainly by Consumers

If a demand curve is relatively steep, the demand is price inelastic. If the supply curve is relatively flat, the supply is price elastic. When demand happens to be price inelastic and supply is price elastic, the majority of the tax burden falls upon the consumer.

In the graph above, the total tax paid by the producer and the consumer is equal to P₀ – P₂. The tax paid by the consumer is calculated as P₀ – P₁. The tax paid by the producer is calculated as P₁ – P₂.

The more inelastic consumer demand is, the less the quantity demanded by the consumer changes as price increases – this is why they absorb the majority of the tax burden in such a scenario.

Excise Tax Paid Mainly by Producers

If a demand curve is relatively flat, the demand is said to be price elastic. It means that the quantity demanded is highly sensitive to changes in price.

The relatively steep supply curve indicates that supply is price inelastic. It implies that the producers likely incur high shutdown costs to stop operations, and that quantity supplied is not very sensitive to price.

In the graph above, the total tax paid is equal to P₁ – P₂. The tax paid by producers is equal to P₀ – P₂.

Learn More

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Supply and Demand
• Economic Equilibrium
• Demand Curve
• Market Indicator
• See all economics resources