Analyst perspective: who really pays for taxes?

In our work as policy analysts, we rely heavily on some of the fundamental theories of economics in order to determine the value of impacts. This has recently come up in a research project we are currently working on, where we need to estimate the elasticity of demand for a good in order to understand what the effects of an excise tax will be. In particular, we are looking at the market for recreational marijuana.

Briefly, the elasticity of demand (or supply) is a numerical measure of how much effect a change in price has on the quantity demanded. For example, if a 1% increase in the price leads to a 2% decrease in quantity demanded, then we say a good has a demand elasticity of -2. 

There are many important results that we can derive from elasticities, but I want to focus on how they interact with taxes. Consider a competitive market for a good that we want to tax:

We can see in our simple setup that the demand curve is much steeper (more inelastic) than the supply curve. Intuitively, this means that changes in price have little effect on the quantity demanded. Conversely, the supply curve is quite flat, suggesting that a small change in price would have a large effect on the quantity supplied. In the above picture, the new tax we are adding to this market is represented by the vertical dotted line, often called the tax wedge. 

Because demand is more inelastic than supply in this market setup, the consumers of this product will have a higher tax incidence. In other words, a larger percentage of this tax will get passed onto them. If we assume that this is a flat $10 tax per item sold, then this tax might  cause the price consumers pay to rise by $8 (the suppliers eat the other $2 via lost revenue).

Who ends up paying for taxes is an interesting question in its own right. In our forthcoming cost-benefit analysis of recreational cannabis legalization in Ohio, this matters to us because we need to fully understand how the proposed excise tax will impact consumer surplus.

As a reminder, consumer surplus represents the difference between the cost of a good in a market and people’s willingness to pay for that good. If people are willing to pay large amounts, but the market price for a good is very cheap, then there is large consumer surplus. People are getting a lot of value for the price they pay. 

In our model for the benefits of legalizing recreational cannabis, one of the major components is going to be how much consumer surplus is generated in a regulated and taxed market. In order to accurately estimate this, we will need to know about the elasticities in our market so that we can accurately assign the tax incidence. 

In practice, this is going to require empirical data. There are econometric methods for estimating supply and demand curves, and because many other states have legal cannabis markets we should have some data to work with. 

Hopefully, we can accurately predict the shape of the recreational cannabis market in Ohio. Then, it will be up to the voters to decide whether they want this market to exist in November.