tax on tobacco allows the government to gain revenue, this can be used in the
provision of public goods such as national defence by better equipping the
military or improving other important sectors such as education through
creating more schools. The tax will only affect those who continue to purchase
these goods, therefore the external cost is being internalised.
the imposition of an indirect tax on cigarettes should reduce the consumption
of these products. However, in the real world ceteris paribus does not hold and
this is because of factors such as the Price Elasticity of Demand (PED). The
responsiveness of demand to a change in price is the PED, if the value of the
PED is 0, this means it is perfectly inelastic. Consumers do not act rationally
and therefore they will be unresponsive to a change in price. This is a result
of habitual consumption and addictions to cigarettes. The diagram below
illustrates the effect of a tax with a perfectly inelastic demand. As supply
decreases from S – S1, the quantity remains the same at Q and demand
is unchanged even as the price rises from P – P1. The area shaded C
shows that the burden of tax lies solely on the consumers, this means that the
producers passed on all the taxes to consumers as higher prices and so they are
not affected by the tax and have no incentive to reduce supply in the long run.
The main purpose of an indirect tax is to increase the cost
of production for producers causing supply to decrease. In response to indirect
taxes producers could release workers to reduce their costs. This increases unemployment,
which is a counter to a main macroeconomic objective that is to reach full
employment. This is an example of government failure, when government
intervention in markets leads to a further misallocation of resources.
Subsequently, these taxes can be harmful to industries as it reduces the total
revenue of firms.
Another major drawback is the fact that Indirect Taxes are
regressive. This means they have a larger affect on poor people than rich
people because they take a higher proportion of poorer individuals earnings.
This further widens the inequality gap and could lead to more people seeking
benefits from the government.
There are other methods of government
intervention that could be used to correct this market failure of negative
externalities. A subsidy is a grant given by the government to producers in
order to reduce their costs of production, subsequently increasing the
production of the good. Merit goods such as water and other healthy drinks with
no added sugar could be subsidized as they have positive externalities
associated with their consumption. The diagram shows that a subsidy increases
the supply of the healthy drinks from S – S1 and so the price of these drinks
will fall from P – P1. There is an extension in Demand and an increase in
quantity sold. This will be a better option than an indirect tax because it is
producing goods that will be under provided and under consumed in a free