Taxation

Question 1

The purpose of taxation

Answer 1

1. Raise tax revenue to fund things that provide positive externalities
2. Use tax to reduce consumption and production of goods that have negative externalities

Question 2

Types of tax

Answer 2

1. Direct tax
- taxes that cannot be avoided, applied directly to your income

2. Indirect tax
- taxes that can be avoided, applied on goods and services

Question 3

What happens once a tax is imposed?

Answer 3

• the supply curve shifts to the left as firms costs of production increases and so it is less profitable to supply
• there is a contraction on the demand curve as firms pass on the cost to consumers by increasing the price

Question 4

Application of a tax to market failure

Answer 4

As a tax is imposed, firms costs of production increases and so the MPC curve shifts to the left as it is less profitable
- We assume the government have perfect information and will set to the tax the exact size of the negative externality in order to shift Qm back to Q tar
- This internalises the externality

Question 5

Advantages of a tax

Answer 5

1. Solves market failure

2. Encourages healthier and cheaper alternatives
- causes less consumption of harmful goods

3. Tax revenue is generated
- the government collect a lot of tax when it is an inelastic good
- can use the tax revenue to hypothecate for subsidies to firms providing healthier and less harmful goods
- if the demand is elastic putting a tax would cause demand to decrease more than proportionally which is beneficial for harmful goods

4. Market-based solution
- haven’t banned the market completely but have internalized the externality

Question 6

Disadvantages of a tax

Answer 6

1. Depends upon the good you are taxing
- if the good is elastic or addictive it is less ineffective in reducing over consumption
- If the good doesn’t have any close substitutes demand will only fall less than proportionally and so still above socially optimum

2. Difficult to know how much tax to impose
- gov doesnt have perfect info so can’t always quantify everything and measure the size of the externality exactly
- This the tax set could be too big or too small
- if the Taxes too small there could still be allocative inefficiency as still too many resources are being allocated and still overconsumptions so the problem is only partially resolved
- If the tax is too big firms are going to set prices too high which leads to the formation of shadow markets which leads to even more externalities and les tax revenue
- this can also lead to under consumption

3. Tax imposed may have regressive effects
- this will take a large proportion of income for low-income households which increases incoming a quality
- firms don’t pay the tax themselves and pass on cost to consumers by increasing price

4. Substitute goods may be harmful
- if tax something comfortable in order to reduce the mind consumers may switch to more harmful alternatives that are cheaper from Shadow market

5. Demerit good
- tax is not effective as it is caused by information failure and a tax can’t change that