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 government receives the tax per unit multiplied by the number of units still sold after the tax.
tax revenue
tax revenue
Assumes: Units keep being sold in their taxed form.
But: Producers can reformulate to escape the tax, which shrinks the tax base.
3
Since demand is price inelastic, sales fall only a little, so the revenue raised is large.
PED · tax base
PED · tax base
Best link to attack
Assumes: Demand for the taxed product is price inelastic.
Assumes: Demand for the taxed product is price inelastic.
But: When good substitutes exist or the product can be changed, the tax base shrinks sharply; revenue from the soft drinks levy came in below early forecasts because so many drinks were reformulated.
4
Therefore, the government gains revenue it can spend on related aims, such as school sport or healthy eating, or use to cut other taxes.
hypothecation · tax revenue
hypothecation · tax revenue
Assumes: The revenue is a net gain.
But: Collecting the tax and checking compliance cost money, so the net gain is smaller than the revenue raised.
End
Tax revenue rises, by more when demand is inelastic and the product cannot be changed to avoid the tax.
Evaluation chain
- E1However, the revenue raised depends on how little the tax changes behaviour.
- E2If the tax works well as a corrective tax, consumers and producers switch away from the taxed product.
- E3As a result, the tax base shrinks and revenue falls, as happened when drinks firms cut sugar to avoid the levy.
- E4So the more a tax corrects the market failure, the less revenue it raises; large revenue is a sign that behaviour has changed little.
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 why the revenue from an indirect tax depends on price elasticity of demand.
- Assess whether a tax on sugary drinks is a good way for the government to raise revenue.
- Discuss the conflict between raising tax revenue and reducing consumption of a demerit good.
Diagram
Supply shifts up by the tax. Tax revenue is the rectangle between the price consumers pay and the price producers receive, multiplied by the new quantity. Compare a steep and a flat demand curve to show revenue is larger when demand is inelastic.
Reverse and related
Cutting the tax → revenue falls, unless sales rise enough to offset the lower rate.