6.1 Indirect Taxation and Market Failure Flashcards
What is an indirect tax?
An indirect tax is a tax levied on goods and services rather than on income or profits. It can be passed on to consumers in the form of higher prices.
Draw the diagram too
How does a carbon tax affect the market?
Indirect taxation to solve negative externality in production diagram
A carbon tax increases the costs of production for polluting firms, shifting the MPC curve upwards from MPC to MPC+tax, equal to MSC. The price increases in the market from P1 to P, with quantity decreasing from Q1 to Q, the socially optimum level of output. The externality has now been fully internalised with the price reflecting the full social cost of production, hence the polluter is now paying the full cost of their actions. The overproduction and overconsumption that existed in the market is now solved with resources allocated efficiently at Q*.
Draw the diagram
What is the impact of an indirect tax on consumption of cigarettes, alcohol, and sugar?
Indirect taxation to solve negative externality in consumption diagram
An indirect tax such as a cigarette, alcohol or sugar tax increases the costs of production for firms, shifting the MPC curve upwards from MPC to MPC+tax. The price increases in the market from P1 to P2 and due to the law of demand, consumption is discouraged, decreasing quantity from Q1 to Q, the socially optimum level of output. The externality has now been fully internalised with the overconsumption and overproduction issues now solved. There is no longer a misallocation of resources with resources allocated efficiently at Q.
Government revenue: P*ABC
What is the wider benefit of an indirect tax?
An indirect tax generates government revenue, which can be used to further solve the existing market failure, for example, by subsidising better alternatives, funding advertising campaigns, providing education or funding alternative/complimenting policies.This is can also be referred to as the government hypothecating the revenue from the tax. This wider benefit can jusitfy the use of indirect taxation even if the tax itself is ineffective in fully reducing quantity to the socially optimum level.
For De-merit goods with inelastic demand
What is the first disadvantage of using an indirect tax to solve market failure?
Cons/Evaluation
The demand for cigarettes, alcohol, sugar and fuel is price inelastic, meaning that as price increases, quantity decreases, but proportionately less than the price increase. This is because they are eitherm necesseities, addicitive. or there aren’t many good subsitutes available. Therefore as price increases, quantity decreases from Q1 to Q2 due to the law of demand, but proportionately less than price increase from P1 to P2. Therefore, the decrease in quantity will help to reduce the misallocation of resources but not by enough to fully solve the market failure if Q* is below Q2. Any overconsumption and overproduction problems will remain.
Knowing the correct tax level to set
What is the second disadvantage of using an indirect tax to solve market failure?
Cons/Evaluation
Knowing the correct level of taxation to set is extremely difficult for the government because putting an accurate value on the negative externalities generated is highly complex. As a consequence, the tax might be set too low where the externality is not internalised, thus the price increase is not large enough to reduce quantity to the socially optimum level of output. If the tax is set too high, there are many unintended consequences that can lead to government failure, where the costs of intervention outweigh the benefits (i.e a black market may form, consumers may go across the border to smuggle goods which leads to decreased tax revenue for the government)
What are some unintended consequences of setting the tax too high?
Cons/Evalutation
Firms may shut down or leave the country causing unemployment. A black market may form where consumers can find alternative supply at a lower price, which could be highly dangerous for the consumer, as they do not know exactly what is in the product they are consuming, with it potentially being more harmful for them than the product consumed legally, worsening the extent of the negative externalities generated. Consumers may go across the border and smuggle goods where taxes are lower or non-existent, which will not reduce consumption and further will not generate any tax revenue for the government.
Regressive?
What is the third disadvantage of using an indirect tax to solve market failure?
Cons/Evaluation
Indirect taxes are regressive, meaning they take a greater proportion of the poor’s income than they do of the rich, thus widening income inequality in society. Consumers are burdened even more if the demand for the product is price inelastic due to the good being addictive in nature, perhaps. In this sense, producers know that they can transfer more of tax onto consumers with there being a proportionately smaller decrease in quantity demanded, burdening low income consumers the most.
