The article discusses the increase of indirect tax for cigarettes by 35p in the United Kingdom to reduce smoking. Cigarettes are demerit goods which are goods that cause negative effects on the consumers. Negative externalities of consumption of cigarettes which create external costs to the third parties is one of the examples of market failure.
Allocative efficiency is achieved when marginal social cost (MSC) is equal to marginal social benefit. (MSB). Negative externalities of consumption occurs when marginal private cost (MPC) is greater than MSB. The difference between MSB and MPB is the negative externalities. Since the smokers only consider private benefits, the intersection of the MPB and MPC curves will be the market equilibrium. In this case, cigarettes are over-consumed. This causes welfare loss which is shown by the shaded area.
When indirect tax is imposed the supply curve shifts upward from MSC to MSC+tax making the supply for cigarettes decrease from .When MSC+tax curve shifts until it intersects with MPB at Pe, the quantity of cigarettes demanded decrease from Q1 to Qe. The price of cigarettes increase from P1 to £8.82.
The price elasticity of demand (PED) for cigarettes are inelastic while the price elasticity of supply (PES) for cigarettes are elastic. This means that the value of PED is less than the value of PES. Therefore, this affects the tax incidence. At point A, the market is at equilibrium. When the indirect tax is imposed, the supply curve shifts upward from S to S+tax and the price increase from Pe to P2. However, there is an excess supply so the producers have to reduce the price from P2 to P1 in order to achieve equilibrium. The demand for cigarettes are relatively inelastic as they are addictive. So, producers can pass on a relatively large burden of the tax on consumers. The shaded region shows tax burden for consumers and producers.
According to the article, imposing the tax can cause consumers to purchase cigarettes at other places with lower cost. Thus black market will be formed. One of the biggest advantage of indirect tax is its regressive nature. This means that all consumers must pay the same amount of tax regardless of their wages. Therefore the consumers with lower income will be burdened even more since they have to pay larger proportion of their income than the consumers with higher income do. This leads to the increase of inequality of income. The imposition of indirect tax can also reduce the producers revenue. This may cause higher rate of unemployment. Since most of the workers in cigarettes companies are in charge in manufacturing cigarettes who have limited skills, it would be harder for them to find other jobs at other places. Moreover, the outcome of the tax which is to reduce the consumption of cigarettes would not be achieved as desired. Since the price of elasticity of demand (PED) for cigarettes are low, the consumption of cigarettes would be low only in the short run.
The advantage of indirect tax would be the increase of government revenue. As the PED for cigarettes are low, the quantity of cigarettes change by a proportionately smaller amount than the change in price of cigarettes. The government can use the revenue to correct the negative externalities by funding anti-smoking campaigns and advertisements. Furthermore, there would greater reduction of cigarettes consumption as PED for cigarettes will increase over longer time period as consumers will try to seek alternative products that they can switch to.
To a certain extent imposing indirect tax on cigarettes is effective to reduce consumption of cigarettes among young generation as they have higher PED because they are considered not addicted to cigarettes. So there would be greater decreases of quantity of cigarettes demanded as the price increase. Hence there would be a greater fall in smoking rates in the community. On the contrary, longer-term smokers have lower PED of cigarettes as they are addicted to cigarettes. Therefore, imposing indirect tax would be less effective to reduce smoking.