The Economics of the Airline Tax

Every so often, policy makers stumble into a natural experiment which permits economists to test their theories (and journalists to generally ignore their theories). Such was the case with the recent suspension of airline taxes.

After a budget showdown allowed the lapse of several airline taxes, most U.S. carriers promptly boosted their prices. As USAToday reported, fliers were “irked.” Ironically, this little incident actually illustrates the fact that the airlines, not consumers, bear most of the burden of these taxes. Instead of being irked, we airline consumers should be grateful that airlines typically shoulder most of the burden of these taxes.

To help illustrate this point, I’ve created some dynamic graphs in the YouTube video below. The price that emerges in a market is the result of the intersection of supply and demand. But when a tax is imposed, it shifts the supply curve up and to the left. This has two effects: a) it lowers the price that producers receive (which is the quoted, pre-tax price you see on the item), and b) it raises the price that consumers pay (the net-of-tax price when you check out).

In some industries supply is not particularly responsive to changes in price. That is, a higher price tends not to induce a big supply response whereby producers are willing to offer more of the product. In these instances, supply is said to be “price-inelastic” and the supply curve is much steeper.  The airline industry is a perfect example. It takes a lot of planning to start up a new airline and existing airlines find it difficult to quickly expand their operations. For this reason, the industry’s supply curve is relatively steep. What impact does a tax have in an industry like this?

The last graph shows us. With a steep supply curve, most of the impact of the tax is concentrated on the first effect: lowering the price that producers receive. Thus, when you remove the tax, the price producers receive goes up and we see that they were the ones who were paying the burden of the tax all along. Similarly, when the tax is re-imposed as it was last week, the price the producers receive tends to go back down. For that, the airlines should be irked.

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Addendum: I’ve slowed the video down a bit to make it easier to read. Thanks to helpful readers for the suggestion.