Question

12. Governments have typically levied high excise duties on goods such as alcohol, tobacco and petrol. a.  Explain why there might be two quite different motives for such taxes and how these may have changed over time? b.  Illustrate the impact of such taxes on an appropriate diagram(s) and explain the demand conditions under which the policies are more likely to be effective. c.   Compare the outcomes and the welfare consequences under the different demand conditions in (b) above.

Answer 1

Q12) Excise duties are a kind of indirect tax which is levied by the government on the sales of particular goods which are manufactured in the country. It is generally paid by the manufacturer of the goods when they introduce the goods into the market. However, it may be passed onto the customers by the producer, as a part of the product price.

a) There may be two different motives of the government behind levying high excise duties on goods like alcohol, tobacco and petrol. The first reason may be to ensure that the economy is running smoothly, incorporating every sector into taxation, either directly or indirectly. High excise duties increases the Federal tax revenues and totalled to a huge amount of $100 billion in 2019, or a 2.9% of the total Federal tax reciepts. Now, the total excise tax revenue is divided into two parts, one being the general funds and the other being the trust funds, with a 40-60 ratio respectively. These trust funds in turn finance all expenditures of the government related to transportation as well as environment and health related.

The second motive behind levying such high taxes is to reduce its production and supply. Excise tax increases the production cost, discouraging sales, when the government thinks the goods are harmful for the public or the environment such as alcohol, tobacco or petrol. It also prohibits the sale of spurious liquor. Such duties are also levied on non-renewable sources like petrol to reduce its demand, and conserve the natural resources and keep the environment cleaner.

However, excise tax revenue as a percentage of GDP has continued to fall over the years and in recent years has been seen to be roughly 0.4%. It fell from 2.7% in 1950 to 0.7% in 1979 and further over the years. The five major categories on which these duties are levied are highway, aviation, alcohol, health and tobacco.

b) Now, the different demand conditions reacting to this policy depends upon the price elasticity of demand. Price elasticity of demand is the degree to which the demand changes as there is a change in the price. In general conditions, people demand a good lesser when its price increases. Now, price elasticity of demand may be of three types:

1) Elastic demand: In this case, buyers are highly price sensitive. So, a rise in price will be more than offset by a fall in demand, reducing the total revenue.

2) Inelastic demand: In this case, buyers are not that price sensitive, such as in the case of necessities. So, a given rise in the price will result in a smaller proportion of fall in demand, so that the overall revenue increases.

The flatter the curve the more elastic it is, the steeper the curve, the less elastic i.e. inelastic it is.

So, let us see the the effect of higher excies duties on the different demand conditions:

So, suppose for people who are addicted to alcohol and tobacco, or who drive to work everyday, i.e. need considerable amount of petrol in their daily lives, they will have a demand which is inelastic and increasing the price of such products due to higher excise duties wont show much reduction in their demand. So, in fig 1(a), you can see that higher excise duties will reduce the supply, shifting the supply curve to the left, which will change the equilibrium. These taxes are passed along to the customers, in the form of higher prices, which will raise the fed tax revenue but not affect the quantity of smoking much. So, this will make the 1st policy or reason to be more effective.

Now, if the goal of the government is the effectiveness of second policy, then it takes place when the demand for such products is elastic such as youth smoking, or people who do not drive on a regular basis etc. In this case, take a look at fig 1(b), the increase in excise duty will shift the supply curve left, but as the demand is elastic, it would reduce the quantity demanded of such goods substantially. Higher costs will be passed on to consumers who will demand less, and the equlibrum quantity will decline by much. This will lead to a lower tax revenue for the Fed, but people will refrain from buying these products.

c) Genrally speaking, the burden or incidence of a tax falls on both the producers and the consumers of the taxed product. However, the elasticity of demand and supply decides which group bears the most of the burden.

So, as we saw in part (b), suppose the demand of consumers is less elatstic i.e. inelastic as compared to the supply fo the producers, consumers are not that responsive to the price change. The quantity demanded remains almost constant and the sellers can pass over the burden of the tax in the form of higher prices to the consumers without much decrease in the quantity demanded. There is a large diff between the price buyers pay now and the equilibrium price before, PE and PT. Sellers also recieve a lower price than before, but this difference, between PE and PP is much lower , but thsi change is much smaller. So, teh burden of taxation is more on the consumers. The shaded area can be referred to as the tax revenue which is the difference in the price times the quantity demanded QT. Take a look at fig 2(a)

Now, in case the supply is inelastic and the demand is elastic, puts the tax burden on the sellers as they cant change their price as easily. So, the price paid by the consumers includes the part retained by the seller and the part paid to the givernment. The price retained by the sellers is much less than the equilibrum price, the difference between PE and PP is quite high and the difference between the price buyers have to pay and the eqilibrium price is not much. So, much of the tax buredn is on the sellers. The tax revenue is given by the shaded area, by multiplying PPPT and QT which si the quantity demanded and supplied after the incidence of tax. See in fig 2(b)

Now, there is also something known as deadweight loss which determines the welfare in the economy. It can be defined as the loss of economic efficiency and welfare due to the reduction in the surplus of the consumers and producers due to taxation. There is reduction of benefit to the participants in the market which reduces their motivation or incentive of trading. So, there will be a reduced trade from both the sides and this less efficient market mechanization is known as the deadweight loss of taxation. This causes wastage or underutilization of resouces and factor of production due to inefficiency in the market. Take a look at the shaded parts on the Fig 2 (a) and (b) to determine the deadweight loss and the loss of welfare.

Also, when comparing consequences, when the demand in elastic, less people will buy the products like tobacco, alcohol and petrol, indicating better for punlic health and environment. So, though, there's loss of welfare due to taxation, a part of it may be offset by the policy. However, if demand is inelastic, there wont be much reduction in the demand, consumers will have to pay higher prices, the policy won't be effective in increasing welfare and it won't do anything better for the economy as a whole.