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Incidence of Federal Ad Valorem Taxes

Thanks to a change in federal law, we have a natural experiment that determines in which markets consumers bear the full incidence of sales taxes. On July 1, 1965, the federal ad valorem taxes on many goods and services were eliminated, and the 10% tax on automobiles was reduced to 7%. By the end of 1965, taxes on admissions to theaters, variety shows, and athletic and racing events, as well as on club dues and initiation fees, were also canceled.

Comparing prices before and after this change, we can determine how much the price fell in response to the tax's elimination. When the tax was in place, the tax per unit on a good that sold for p was ap. If the price fell by ap when the tax was eliminated, consumers must have been bearing the full incidence of the tax. Consequently, consumers got the full benefit of removing the tax from those goods.

Brownlee and Perry (1967) found that the entire amount of the tax cut was passed on to consumers immediately for many commodities. These commodities and services included all those studied for which the taxes were collected at the retail level (except admissions and club dues) and most commodities for which excise taxes were imposed at the manufacturer level. Goods for which consumers got essentially the entire tax cut included face powder, sterling silverware, wristwatches, and handbags. When the supply curve is nearly perfectly elastic, we would expect the full incidence of a tax—and hence the full benefit of the tax cut—to fall on consumers (see Chapter 3). A perfectly elastic supply curve is likely when all firms have the same costs, as we might expect in retailing. The full incidence of the tax also falls on consumers if the demand curve is completely inelastic.

Essentially none of the tax savings were passed on for motion picture admissions and club dues. We would expect this result either if the elasticity of demand were perfectly elastic or if the elasticity of supply were perfectly inelastic.

The price decline was less than the amount of the tax cut for many lower-valued items on which manufacturers' taxes were reduced. The 10% reduction in taxes led to only a 6.3% drop in prices for portable TVs, 1.4% for golf clubs, and 0.9% for stereo records and golf balls. Thus, for these goods, neither the demand nor the supply curves were perfectly elastic or perfectly inelastic.

SOURCES: Brownlee, Oswald, and George Perry, "The Effects of the 1965 Federal Excise Tax Reductions on Prices," National Tax Journal, 20(3), September 1967:235-249.

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