2.a) Explain why a government might decide to impose an indirect tax on the consumption of cigarettes.

[10 marks]

Answer:

An indirect tax is defined as a tax imposed on a good or service itself rather than on a consumer or household’s
income. For example, a $1 tax placed on demerit good such as cigarettes or alcohol. Demerit goods are defined as
good that are innately bad for consumers, but are still consumed regardless. Stakeholders are defined as the
different groups involved in a market. These stakeholders are usually known as consumers, firms, workers, and the
government.

The government might decide to impose an indirect tax on the consumption of cigarettes as a disincentive for
consumers to consume the demerit good, reducing the effect of negative externalities in the market and even to
collect a good amount of tax revenue which can be used for government spending. A negative externality is
defined as a spillover effect that results from a market that harms a third party not involved in the said market.
The disincentive to consume cigarettes that the government is aiming for as they want to lower consumption of a
good that ultimately harms the consumer, as per their role, is made possible due to the law of demand. The law of
demand states that when the price of a good increases, the quantity demanded falls as price and quantity
demanded have an inverse relationship. Thus, when the government imposes a $1 indirect tax on a cigarette, they
raise the price of the cigarette, which in theory should lower the consumption of the cigarettes as less is
demanded. This can be seen in the graph depicted. The indirect tax shifts the supply curve, from S to S+tax, to
reflect this increase in price, which is what causes the quantity demanded to fall, showcased by Q1 minus Q2, a
lower quantity demanded indicated by it being closer to zero.

This lower consumption of the demerit good is what causes the reduction of the negative externality of
consumption caused by the cigarettes. When cigarettes are consumed, the marginal social benefit (MSB) is much
lower than the marginal private benefit (MPB) as the consumption of cigarettes produces second hand smoke,
which harms the health of individuals who didn’t choose to consume the cigarette, and thus MSB˂MPB: spillover
negative effects on consumers not involved in the market. The market is inefficient showcased by the deadweight
loss. Additionally, while the law of demand does state that higher price equals lower quantity demanded and this
does apply to cigarettes, the quantity demanded will only marginally decrease the consumption due to the
inherent nature of cigarettes. Cigarettes are inelastic good: goods the quantity demanded only changes marginally
with a price change, unlike elastic goods whose quantity demanded changes drastically with a price change. This
can be seen in 2019 when the United States imposed a VAT tax (a type of indirect tax) on e-cigarettes. While the
higher price did deter a number of consumers from consuming e-cigarettes, a huge amount of consumers
continued to buy them at this higher price. However, while this may seem like a terrible thing, the inelasticity of e-
cigarettes allowed for the U.S. government to make a good amount of tax revenue as consumers were still buying
at this much higher price and for every cigarette bought, the government made $1.15 (this was the tax imposed).
The government can then use this tax revenue to give back to the community, in the form of public goods and
other projects. Ultimately, the government is looking to impose an indirect tax on cigarettes to discourage
consumption of health harming demerit goods, reduce negative externalities, and make tax revenue.

2. b) Using a real world example, discuss the possible consequences of the imposition of an indirect tax for
different stakeholders in a market. [15 marks]

Answer:

The possible consequences of the imposition of an indirect tax for different stakeholders in a market is dependent
on the stakeholders, defined in 2.a), themselves and the type of good being taxed. For instance, if an indirect tax is
levied on demerit goods such as cigarettes, or alcohol, then the majority of consumers and the government will
benefit from this taxation, while the firms and the workers will not and will be disadvantaged, in the short run. As
depicted in 2.a) when a tax is imposed on a demerit good, the quantity demanded falls due to the increase in price:
q1 moves to q2 and the supply line (S) becomes the supply line (S+tax). This action of less consumption, caused by
the law of demand, decreases what is known as total revenue for the firms: amount of money made from
consumers buying their goods. Furthermore, in the short run firms will be even more negatively impacted by the
tax as they can not only receive less total revenue but they are not able to immediately lower wages for their
workers, and they still have the same costs of production with just less revenue. This will lead to a massive loss in
total profits (profits is amount of money made when profits are subtracted from total revenue). This can be seen
by the E-cigarette company Juul in 2019 reporting a $500 million loss in profits once the United States government
implemented a 17% VAT on all e-cigarette products. In the long run, firms will be able to lower their costs of
production, and receive more profit. However, this in return to workers in the long-run being negatively impacted
as a majority of them will be fired in order to cut costs and the rest lowered wages. This can again be seen in the
U.S. with the e-cigarette company Juul who reportedly fired 30,000 workers in the next 6 months of the tax
imposition and lowered the wages of the rest. However, as previously stated, stakeholders such as consumers and
the government mostly benefit from an indirect tax in the market, in both the short run and long run. As stated in
2.a), an indirect tax leads consumers consuming less of a demerit good that harms their health in both the short
and long run., consumers not involved in the market will be harmed less by second hand smoke as there will be
less of it in the short and long run and governments will have increased tax revenue in the short and long run to
fund projects like public goods that will help consumers in the long-run. These effects can again be seen by
analyzing the implementation of a 17% VAT on e-cigarettes in the United States’, teenagers were reported to be
spending less money on e-cigarettes like Juul, and the government reported being able to fund more public goods
like a park. Ultimately, while firms and workers will have negative consequences from the implementation of an
indirect tax on a market like the cigarette/e-cigarette market, the collective society will benefit as a whole, evident
by the positive consequences to the government and consumers. This makes it worthwhile to impose an indirect
tax in a market, especially on a demerit good. However, there are some limitations to an indirect tax. Firstly, due to
the regressive nature of the tax (regressive taxes are defined as a lower tax on higher-income individuals
compared to that of higher-tax, proportionally, on lower income individuals), lower income individuals who are
addicted to demerit goods such as cigarettes will be harmed more by the tax than that of higher-income
individuals who is addicted, which the tax has no ability to change due to the nature of it. Higher-income addicted
teens will usually pay the new amount, while lower-income individuals also are addicted will most likely struggle to
pay it, and will need to use money that could now give into other merit goods, in cigarettes, and the tax has no
way of addressing theirs.

Furthermore, for a government to impose an indirect tax and expect it to achieve the sought out positive income,
they have to assume that consumers will behave rationally, and at their own self-interest. However, due to
behavioral economics, we know this isn’t always the case due to stuff like bounded self-control, individuals will
most likely continue consuming cigarettes at the same rate because of addiction, while the point of the tax is to
discourage this, and this bounded self-control causes it to not work on everyone. Nevertheless, as shown in the
Juul 2019 example, consumers will most likely behave rational $500 million loss in profits is due to consumers
consuming less products. If the government is to impose an indirect tax, it should be imposed on demerit goods,
which may or not be inelastic, instead of merit goods. Imposing a tax on merit goods would not help consumers a
lot, and would especially harm workers addictions if the good is elastic. Indirect tax on a merit good will not have
the same effect on consumers and will most likely not result in an increase in tax revenue.

Finally, when looking at the pros and cons for the indirect tax in a market for a demerit good, it is evident that it is
advantageous: while yes, firms and workers may be negatively impacted, the positive societal impact it will have
outweighed this.

Markscheme: