The Effect of Tax on the Demand Curve

Economists are often concerned with the effect of government policies like taxes or subsidies on the interaction of supply and demand. Extensive study in economics has considered this issue, and theories exist to explain the relationship between taxes and the demand curve. Understanding the basics of the effect of tax on the demand curve is important both for business and those interested in economic policy.

In economics, the demand curve is a graphical approximation of consumers' buying interest. It is often used hypothetically to help explain and visualize economic theories and phenomena. The points along the demand curve represent price points at which given a quantity of consumers intend to make a purchase. For most products, economists generally assume that the demand curve is declining—as price increases, consumption quantities will decrease. This is because fewer consumers will be willing or able to pay higher prices for goods, and those that still consume may do so in lower quantities.

Changes in market and regulatory conditions may cause the demand curve to shift. This is because the effects of certain policies, events or even the prices of other products may impact a consumer’s willingness or ability to consume. As their willingness or ability to consume is reduced, the curve is said to shift “to the left” in two-dimensional graphs where quantity is represented on the x-axis and price on the y-axis. If consumer demand increases and consumers are willing to pay more for a good or service, the curve shifts to the right.

Taxes are among the market and regulatory conditions that define the demand curve. If a new tax is enacted, the demand curve may be expected to shift depending on the tax. A tax on buyers is thought to shift the demand curve to the left—reduce consumer demand—because the price of goods relative to their value to consumers has gone up. It is important to remember, though, that taxes finance government spending, which also contributes to the position of the demand curve. When government spending increases, so does aggregate demand. In some cases, a tax may cause a decrease in demand of products consumed primarily by individual consumers and an increase in demand of products consumed primarily by firms or government. In some cases, a government may impose a tax on a certain good—such as tobacco or alcohol—with the specific intention of reducing the quantity that is consumed.

One potential result of a decrease in demand resulting from a tax on buyers is that fewer products will be consumed. In turn, this may cause producers of taxed product to lower their quantity of production and lay off workers. Whether or not production decreases result from taxes on buyers is somewhat dependent on the elasticity of the good subject to tax—the degree to which price determines quantity. The consumption of some goods, called inelastic goods, varies little according to price. In these cases, it is possible that consumers will simply pay the higher tax and continue to demand similar quantities of a product as they did before a tax was imposed.