WHO PAYS THE LUXURY TAX?

In 1990 Congress adopted a new luxury tax on items such as yachts airplanes furs jewelry and expensive cars. The goal of the tax was to raise revenue from those who could most easily afford to pay. Because only the rich could afford to buy such extravagances taxing luxuries seemed a logical way of taxing the rich.

Yet when the forces of supply and demand took over the outcome was quite different from what Congress intended. Consider for example the market for yachts. The demand for yachts is quite elastic. A millionaire can easily not buy a yacht she can use the money to buy a bigger house take a European vacation or leave a larger bequest to her heirs. By contrast the supply of yachts is relatively inelastic at least in the short run. Yacht factories are not easily converted to alternative uses and workers who build yachts are not eager to change careers in response to changing market conditions.

Our analysis makes a clear prediction in this case. With elastic demand and inelastic supply the 

burden of a tax falls largely on the suppliers. That is a tax on yachts place a burden largely on the firms and workers who build yachts because they end up getting a lower price for their product. The workers however are not wealthy. Thus the burden of a luxury tax falls more on the middle class than on the rich.

The mistaken assumptions about the incidence of the luxury tax quickly become apparent after the tax went into effect. Suppliers of luxuries made their congressional representatives well aware of the economic hardship they experienced and Congress repealed most of the luxury tax in 1993.