Examine the Importance of the Elasticity of Demand in a Government Decision to impose a Specific Tax on the Buyers of Cigarettes
In macroeconomics, taxation is the basis of Fiscal Policy in which the government tries to influence the economy. The Government can then use this tax revenue for public goods such as Roads, Hospitals, Education etc. In this case because the tax is specific, it is a type of indirect taxation that is not based on the value of the goods only the quantity, unlike an Ad Valorem Tax such as VAT that is a percentage of the price of the good, but is also added to the price of cigarettes.
Looking at the second part of the question, Own-Price Elasticity of Demand measures the effects of changes in price of a good to the changes of demand for that same good. Therefore as in this example, because ciggarettes contain niccotine we must look at the addictive element that ciggarretes cause and what effects this would have on demand. Obviously because of this, ciggarettes are in fact an inelastic good due to changes of price having very little effect on the demand. Due to PED=%∆Q / %∆P inelastic goods have a PED<1, hence the gradient of the graph in Figure 1. Note: PED is always a negative so there is no need to put a negative sign, we only concentrate on the magnitude of this.
Therefore if this specific tax was to be imposed upon buyers of cigarettes at the point-of-sale, through tax incidence analysis we can see the exact effects. Looking at the graph in Figure 2, we can see due to the inelastic demand of cigarettes creating a steeper sloped demand curve, the tax that is added by the governement creates a ‘wedge’ that increases the price. This is shown by the movement along the demand curve from the original market price before the tax, demonstrated as PO, which is then causes the Supply curve shifting to the left by natrual equilibrium.
The Tax Revenue from this particular policy of the government of shown by orange rectangle in Figure 2; this is given by the Tax/Unit multiplied by the Quantity Deamnded.
Continuing with Figure 2,due to the inelasticity of demand the majority of the tax burden is imposed upon the consumer/buyer i.e. the difference between the original price (PO)and the price paid by the consumer after the tax (PC). The producers i.e. the cigarette manufacturer on the other hand only absorbs the minority of the tax incidence, by paying the minority of the tax i.e. the difference between the original price (PO)and the Price recieved by the manufacturer pre-tax (PS). Also, as shown in Figure 2, the tax causes there to be a loss in both Supplier and Consumer Surplus meaning that less suppliers are willing to enter the market due to a decreased revenue and less consumers are willing to enter the market to buy the good at the increased price.
The last major contributing factor to the tax incidence is called the Deadweight Loss which is shown by the shaded triangle. This demonstrates the loss of economic activity or output due to the tax which has reduced the total surpluses by more than the Government has gained in Tax Revenue. As Mankiw and Taylor (2006) pointed out in their Ten Principles of Economics: People Respond to Incentives; therefore because the market has shrunk below the optimum equilibrium, the taxes have distorted the incentives. This eventually leads to the market inefficency. However, it can be said that this effect is minimised due to the demand for cigarettes being relatively inelastic, meaning that the tax has had an insignifcant effect on the market outcome. Hence, the deadweight loss is minimal in comparison to a more elastic demand curve such as in Figure 3.
So what are the reasons for this direct taxation imposed by the government? Firstly, it may be to increase tax revenues, through fiscal policy, at a time when UK PLC’s budget may be running in a deficit, like it is currently at an estimated £175 Billion. The revenue could then be used to reduce this deficit by paying back the loans used to fund public services. However as shown previously, the majority of the tax burden is placed upon the consumer and not the producer, due to the inelasticity of the good, it cause s
Secondly, as cigarettes are deamed to be a demerit good, meaning that they have an unhealthy or negative affect on directly the consumer, but also indirectly to society as a whole. For this reason it may be possible that SOCIAL COSTS
It is be argued by Koutsoyannis (2003) that all goods are only relatively inelastic up to a ‘tipping point’ when due to the extreme prices they become elastic, however I think this is doubtful in the case of cigarettes as history shows that the price has continued to rise through increasing specific taxes on them, and yet demand has been affected insignifcantly.