Saturday, July 23, 2011

A Natural Experiment in Tax Incidence

Congress has provided us with a natural experiment in tax incidence. They adjourned for the weekend without renewing the FAA's authority to tax airline tickets. That means the taxes won't get collected until they pass the law. In the meantime, the tax rate on tickets goes down. However, that doesn't mean that the total price of a ticket will change.

That gave airlines a choice: They could do nothing — and pass the savings to customers — or they could grab some of the money themselves.

"We adjusted prices so the bottom-line price of a ticket remains the same as it was before ... expiration of federal excise taxes," said American spokesman Tim Smith. US Airways spokesman John McDonald said much the same thing — passengers will pay the same amount for a ticket as they did before the taxes expired.

Tax incidence depends on elasticities. Since the demand is more elastic than supply in the short run, airlines pay most of the tax out of their producer surplus. With the tax unexpectedly going away, the airlines will raise fares and pocket the tax revenue.

Said another way, the short run supply curve is almost perfectly inelastic. There are a given number of seats flying to a destination, no more, no less. Airlines adjust prices to fill the seats. The price the consumer sees is the price with taxes and fees. Since the taxes and fees decreased, the airlines can raise fares and still keep the seats full.

The Transportation Department says it will lose $200 million a week. J.P. Morgan analyst Jamie Baker said airlines could take in an extra $25 million a day by raising fares during the tax holiday.

That's an increase in producer surplus.

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