inverse elasticity rule

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A rule describing efficient commodity taxation in a single consumer economy when there are no cross-price effects in demand. The inverse elasticity rule is obtained by choosing the set of commodity taxes that maximize the welfare of a single consumer subject to the government achieving a required level of tax revenue. The rule is based on the assumption that the demand for each good depends only on its own price so there are no cross-price effects. The conclusion obtained is that the rate at which a commodity is taxed should be inversely proportional to the absolute value of its elasticity of demand. Thus, goods with low elasticities of demand should be taxed relatively highly. The inverse elasticity rule describes an efficient tax structure, so its conclusions are modified when equity considerations are introduced. See also Ramsey pricing.

Subjects: Economics.

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