What Is a Luxury Tax?

A luxury tax is an ad valorem tax placed on products or services that are deemed to be non-essential or unneeded. The luxury tax is an indirect tax in that the tax increases the price of the good or service, a price inflationary burden which is only incurred by the end consumer who purchases or uses the product.

Luxury taxes can also be referred to as excise taxes or sin taxes.

Luxury Taxes Explained

Luxury taxes were often imposed during times of war to increase government revenues, or as a way to get more tax revenue from the ultra-wealthy. Even though some people complain about the preservation of luxury taxes today, the vast majority of people and lawmakers don't mind charging extra fees for the use of these ancillary-type products consumed by a minority of the population. The term “luxury tax” has remained even though many of the products that are assessed with luxury taxes today are no longer seen as luxuries in the literal sense. Today's definition leans more towards vices or "sin" items such as tobacco, alcohol, jewelry, and high-end automobiles. They are implemented as much in an attempt to change consumption patterns as to collect tax revenues.

Since luxury goods are attributed to the wealthy in society, one expects that the majority of taxpayers will not be affected by luxury tax. However, as what is viewed as luxury changes over time, more and more people will be subject to this progressive tax. Goods considered as normal or ordinary goods may be hit with luxury taxes if the government needs to increase its revenue.

In economics, luxury goods are referred to as Veblen goods, which are defined as goods for which demand increases as price increases. Since taxes increase the price of a good, the effect of luxury taxes may be an increased demand for certain goods that are considered to be luxury. In general, however, since a luxury good has a high income elasticity of demand by definition, both the income effect and substitution effect will decrease demand sharply as the tax rises.

There is much debate over whether levying luxury taxes does more harm than good. For example, who is most harmed by a luxury tax placed on an expensive car? The buyer, who presumably has money to spare, or the middle-class worker who builds the car only to see sales fall when the luxury tax curbs demand? In the late 1980s, Canada attempted a large luxury tax on cigarettes, only to find that a substantial and violent black market soon formed to supply smokers. Legal sales (and tax revenues) fell, and more money had to be re-routed to stop the criminal activity.