Use of indirect taxation to correct a negative production externality

Question 1

What is an indirect tax

Answer 1

• Tax levied on the expenditure of a good or service
• Specific
• Ad valorem - VAT at 20%

Question 2

Analysis

Answer 2

• Diagram
• Causes shift inwards of MPC curve
• Firms face higher costs of production
• Forced to internalise the externality - must pay for the external costs generated
• Optimal level of tax would cause the MPC to equal the MSC - size should be vertical distance between MPC and MSC
• The new after-tax equilibrium is given by the intersection of MSC and D
• Lower optimal quantity produced and higher price

Question 3

Analysis 2

Answer 3

• Increased costs of production create incentives for firms to switch to cheaper production methods that reduce the externality - so as to not be taxed
• Lower marginal social cost of producing energy
• Tax generated from the tax can be used to subsidise alternative methods of production - making these alternative methods more cost-effective for firms to switch to

Question 4

Evaluation 1

Answer 4

• Imperfect information - size of the tax must be large enough to correct the externality - government might make incorrect assumptions - not have enough info to make considered cost-benefit analysis - as it is time consuming and expensive
• Taxation may be regressive - low income groups pay higher proportion of their income on the good - adversely effected from price rise - conflicts with greater income equality objective

Question 5

Eval 2 - using elasticities

Answer 5

• Risk that polluting firms may not lower their production
• Demand for the good is price inelastic - the tax incidence can be passed onto the consumer in the form of a higher price
• Production does not significantly fall towards socially optimum level

Question 6

Judgement chain of reasoning

Answer 6

• Ultimate success depends on whether substitute methods of productions can be found to replace the original method
• If tax revenue can be used to subsidise alternative methods which reduce the externality then benefits should outweigh the cost
• Depends largely on the priorities of the government
• Generally politically unpopular so may be reluctant to intoduce them
• Policy may be rendered less effective if costs are simply increased for consumers and there is no incentive to make changes to the production process

Question 7

Benefits of an indirect tax

Answer 7

• Internalises the externality
• Maximises social welfare
• Gov raises revenue