Who Actually Pays the Luxury Tax ?

A new luxury tax was adopted by Congress in 1990 on items such as private airplanes, yachts, furs, expensive cars and jewellery. This tax was imposed so as to raise revenue from those who could most easily afford to pay. Because only the rich could afford to buy such extravagances, taxing the luxuries seemed a logical way of taxing the rich.

This is a good way of taxing the rich, right ? Even you might be thinking that and well done congress, you did a good work!  Every  layman or people without the knowledge of economics would also think that way. But what’s actually shocking is..this isn’t true. How ? Why ? You will find your answer soon.

Just scroll down and read the entire article. 🙂

Yet when the forces of supply and demand  took over, the outcome was quite different  from what was intended  by this new tax policy.

Consider for example, the market for yachts. Their demand is quite elastic. A millionaire can easily not buy a yacht and can use the same money to buy the other extravagances. By contrast, supply of yachts is relatively  inelastic, atleast in short run. The yacht factory cannot  easily shut down or can be convert  to other alternative  uses and workers who provide their labour  for building yachts will not be eager to change  their careers in response to changing  market conditions.

The burden of this tax would fall largely on the suppliers due to inelastic supply  and elastic demand. That is , this tax on yachts places a larger burden on the firms and workers who build  the yachts because  they end up getting a lower price for their product. However, the workers are not wealthy.  Thus the burden of the tax falls largely on the middle class than on the rich.

Why does this happen ?

You might be wondering what elasticity has to do with the tax burden.

The answer  lies here

When a good is taxed ,buyers  and sellers of the good share the burden of the tax. But how exactly is this burden divided? Only rarely will it be shared equally. The incidence of the tax falls more heavily on the side of the market which is less elastic.  This is because, elasticity measures the willingness of the buyers or sellers to leave  the market when conditions become unfavourable. A small elasticity of demand means that buyers do not have good alternatives to consuming  a particular product whereas a small elasticity of supply means that suppliers don’t have good alternatives to producing  that product . Thus when a good is taxed,the side of the market which is less willing to leave the market because it has fewer alternatives has to bear more of the burden of the tax.

Thus unknowingly this luxury tax imposed was repealed in 1993 by Congress when the actual effects of the tax became apparent to them.

Hope you have got your answer now! 😛

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