Should Airlines Raise Ticket Prices During a Tax Holiday?

July 29, 2011

One effect of the current stalemate over the debt limit is the expiration of the Federal Aviation Administration’s operating authority, which happened last Saturday. The agency has been partially shut down for a week, and one casualty is its ability to collect airline ticket taxes. Airlines, as predicted, have responded by raising ticket prices by the amount of the tax, leaving the final price unchanged.

Senators Jay Rockefeller (D-WV) and Maria Cantwell (D-WA) are not pleased, and say that airlines should either pass the savings along to consumers or escrow them in an account that “supports federal aviation programs,” which essentially sounds like asking them to pay the tax voluntarily.

There’s no particular reason the price hikes should be controversial. At the risk of stating the obvious, market economies such as our own depend on the abilities of firms to freely set prices, and the economically correct thing during a tax holiday is to raise prices. Let’s review the basic microeconomics of consumption taxes.

Supply and Demand

The basic effect of a consumption tax on a good is to reduce the supply of that good – in other words, the price is higher at any given quantity, so the supply curve moves to the left. In the charts above, the S1 curve reflects a supply curve assuming no tax, and the S2 curve is the supply curve assuming a consumption tax. The quantity of the good decreases from Q1 to Q2, and the price increases from P1 to P2. In all cases, the size of the gray box reflects the revenue going to the firm; the blue and orange boxes reflect tax revenue going to the government.

In Situation 1, the burden of the tax is shared between consumers and producers. Situation 2 assumes elastic demand – in other words, consumer purchases are very sensitive to price changes. It’s easy to see from the graph that in this situation, the price changes very little, and the firm is unable to pass on the tax to consumers, bearing most of the cost itself. We see the opposite situation in Situation 3, which assumes inelastic demand (in which consumers are not sensitive to price changes.) Here, the price change is significant, and the cost of the tax is borne mainly by consumers.

The fact that most airlines have raised their prices by the amount of the tax suggests that they have determined the market for airline tickets most closely resembles Situation 2, and that demand for airline tickets is elastic. Spirit Airlines did the opposite, and did not raise prices, so perhaps they’ve determined that the airline ticket market looks more like Situation 3. This may or may not be the case, but it’s not for the government to decide that. In a market economy, the government does not set prices. Airline companies are allowed to charge whatever they want for tickets, and should suffer the consequences of those decisions. Elected officials shouldn’t be scolding private companies for obeying the basic rules of Econ 101.


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