ChainWhat it assumes · how to break it
Start
The government imposes a specific indirect tax on a product with external costs, for example the UK Soft Drinks Industry Levy, charged on producers of sugary soft drinks since April 2018 at two rates depending on sugar content.
1
As a result, producers' costs of supplying each unit rise, so the supply curve shifts up vertically by the amount of the tax.
specific tax · supply
specific tax · supply
Assumes: The tax is charged on each unit sold.
But: Producers can avoid a tax based on content by changing the product, as many drinks firms did by cutting sugar below the levy threshold before it began.
2
This means the market price rises, but usually by less than the tax, because producers absorb part of it to limit the fall in sales.
tax incidence
tax incidence
Assumes: Producers compete on price.
But: A firm with market power may raise its price by the full tax, or more, if it expects rivals to do the same.
3
Since demand for branded soft drinks is price inelastic, most of the tax is passed on, so the consumer share of the incidence is large.
PED · consumer incidence
PED · consumer incidence
Best link to attack
Assumes: Demand for the taxed drink is price inelastic.
Assumes: Demand for the taxed drink is price inelastic.
But: Close substitutes such as water, diet drinks and low-sugar versions make demand for any one taxed drink more elastic, so producers absorb more of the tax.
4
Consequently, consumers pay a higher price, buy fewer units and lose consumer surplus, part of which becomes tax revenue and part deadweight loss.
consumer surplus · deadweight loss
consumer surplus · deadweight loss
Assumes: Lost consumer surplus is a true loss of welfare.
But: With a demerit good consumers undervalue the harm to their health, so buying less may raise their long-run welfare even though measured surplus falls.
End
Consumers pay a higher price, buy less and lose consumer surplus, with the burden largest when demand is price inelastic.
Evaluation chain
- E1However, how much of the tax consumers bear depends on the price elasticity of demand relative to supply.
- E2If consumers can switch easily to substitutes such as water or low-sugar versions, demand for the taxed drink is price elastic.
- E3As a result, producers cannot pass much of the tax on without losing many sales, so they absorb more of it through a lower price received.
- E4So consumers pay only a little more and most of the burden falls on producers; the consumer burden is large only when demand is inelastic.
Another way to attack it: The tax is regressive: lower-income households spend a larger share of their income on such drinks, so they bear more of the burden relative to income, though they may also gain most from better health.
Can you say this chain from memory?
Members can hide the links, test themselves and track which chains they have mastered.
Practise this chainMembers can hide the links, test themselves and track which chains they have mastered.
Questions this answers
- Explain, using a diagram, how the incidence of an indirect tax depends on price elasticity of demand.
- Assess the impact of a tax on sugary drinks on consumers.
- Discuss whether an indirect tax is a fair way to reduce consumption of a demerit good.
Diagram
Supply shifts up vertically by the tax (S to S + tax). The price consumers pay rises from P1 to P2 and the price producers receive falls to P2 minus the tax. Shade the consumer incidence between P1 and P2 and the producer incidence below P1; draw demand steep to show most of the tax falling on consumers.
Reverse and related
Removal of the tax → supply shifts down, the price falls by part of the tax, and consumers buy more and regain surplus.