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IAI Actuarial Core Principles · Business Economics · Government intervention in a market

Which feature best explains why governments often tax goods such as tobacco and fuel heavily to raise revenue?

Governments tax such goods heavily because demand is relatively price inelastic. Buyers keep purchasing even at higher prices, so quantity falls only slightly and the tax base is preserved, giving dependable revenue with limited distortion.

  1. ADemand for them is relatively price inelastic, so quantity falls littleCorrect
  2. BSupply of them is perfectly elastic
  3. CThey are always inferior goods
  4. DTheir demand is highly price elastic
  5. They have no negative externalities

Explanation

When demand is inelastic, a tax raises the price but quantity falls only slightly, so the revenue stays high and the efficiency loss is small. Elastic demand would shrink the tax base.

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