Monday, July 25, 2011

A Question About Tax Incidence

A reader alerts me to this story:
The expiration of the FAA reauthorization on Friday means some aviation taxes are no longer being collected. These include a 7.5 percent sales tax on U.S. air transportation and a 7.5 percent sales tax on the purchase of air miles, said fare watcher Additionally, taxes on jet fuel are also reduced.
"Friday evening we adjusted prices so the bottom line price of a ticket remains the same as it was prior to the expiration of federal excise taxes, etc.," [said] American Airlines spokesman Tim Smith.
The reader asks how to reconcile this story with the basic theory of tax incidence, according to which consumers and producers share the burden of taxes.

What a good exam question!  Stop and answer the question yourself before proceeding.  If you need help, click through and read the article.  It provides some clues.

My answer: It appears that the supply of airline seats is perfectly inelastic.  With inelastic supply, the incidence of the tax falls entirely on producers; conversely, all the benefit of the tax cut is enjoyed by producers.

Is the assumption of inelastic supply realistic?  Not generally, but here the situation might be different.  The story goes on to say:

Neidl also said the benefit to airlines would be minimized if Congress reached a deal soon to resolve the partial FAA shutdown.
"It looks to me like it's going to be very temporary," Neidl said. "So whatever effect it has, it's going to be very minor."
In response to a change that is expected to be very temporary, airlines might be reluctant to adjust the quantity of seats supplied.  That is, the assumption of inelastic supply might not be so bad.

If the tax cut were to persist, however, the larger profit margins would encourage a supply response.  In that case, some of the tax cut, perhaps most of it, would be passed on to consumers.