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, the government has to choose a tax rate without accurate information on the marginal external cost.
information gaps
information gaps
Assumes: External costs are hard to value.
But: For some externalities, such as carbon emissions, official estimates of the damage exist, so a tax can be set close to the external cost.
2
This means the tax may be set at the wrong level; if it is above the marginal external cost, output falls below the social optimum.
over-correction · welfare loss
over-correction · welfare loss
Assumes: The tax is set too high.
But: Political pressure to keep prices down often pushes taxes lower rather than higher, so under-correction may be more likely.
3
At the same time, consumers may switch to untaxed products that cause similar harm, such as sweets or milk-based drinks, which the levy does not cover.
unintended consequences · substitutes
unintended consequences · substitutes
Best link to attack
Assumes: The untaxed substitutes are just as harmful.
Assumes: The untaxed substitutes are just as harmful.
But: Many consumers switched to low-sugar versions of the same drinks, which reduces the harm rather than moving it elsewhere.
4
Therefore, a tax that is set at the wrong level or is easily avoided creates a net welfare loss or leaves the market failure in place: government failure.
government failure · net welfare loss
government failure · net welfare loss
Assumes: The outcome is worse than the free market.
But: An imperfect tax may still reduce the welfare loss compared with no intervention, which is not government failure.
End
The tax may create a new welfare loss or fail to correct the market failure, which is government failure.
Evaluation chain
- E1However, whether the tax causes government failure depends on how harmful the products consumers switch to are.
- E2If the closest substitutes are low-sugar versions of the same drinks, switching is what the policy intends.
- E3As a result, sugar intake falls rather than moving to another product, and the levy achieves part of its aim through reformulation.
- E4So government failure is likely only where untaxed products are as harmful as the taxed ones; with the soft drinks levy much of the switching reduced the harm.
Another way to attack it: The tax is also regressive, so it can widen inequality even where it improves health.
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Questions this answers
- Explain how an indirect tax could lead to government failure.
- Assess the extent to which a sugar tax is likely to result in government failure.
- Evaluate the view that taxes on demerit goods do more harm than good.
Diagram
MPC, MSC and demand. Draw the tax larger than the marginal external cost at Q*, so the new output is below Q* and a new welfare loss triangle appears between the new output and Q*.
Reverse and related
Removing the tax → no risk of over-correction, but the original welfare loss from overconsumption returns.