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Effects of Increased Excise Taxes

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Commentary 1

The article discusses the possible effects of the increase in excise taxes (taxes imposed on particular goods and services, such as cigarettes and alcohol aimed at reducing consumer consumption of such goods and services) from 20% to 25% on cigarettes by the West Bengal government of India.

The consumption of cigarettes (demerit good with relatively inelastic demand) causes external costs (costs to the third parties, which are not borne by the producers or consumers of the good/service), like- passive smoking, higher than necessary health care costs, etc.

Figure 1- Market failure diagram for negative externalities of consumption

The initial condition is represented by the intersection of MSB (the additional benefit of the soceity for producing one more quantity of cigarette) curve with MSC (the additional cost borne by the soceity for producing of one more quantity of cigarette) curve at the optimum price and optimum quantity . Since consumption of cigarette leads to negative externalities the MPB (additional benefit of the cigarette consumers of consuming one more unit of cigarette) curve will lie above the MSB curve by the vertical difference of the external costs created by the smokers to the non-smokers of West Bengal. The MPB curve intersects the MPC curve at price and quantity indicating that the market of West Bengal has overallocated its resources to produce cigarettes as > and MSC > MSB at in the diagram above.

Therefore there is a welfare loss of Area X.

To reduce the welfare loss, the government of West Bengal increased the excise taxes from 20% to 25%. Consumers, thus, will experience a higher rate of tax for the external costs they create.

Figure 2- Effect of implementing a higher excise tax

With the imposition of a higher rate of excise tax, the supply of cigarettes will fall further, as shown by the upward shift of supply curve from MPC+ to MPC+ in the diagram above. Previously, when the tax rate of 20% was imposed by the government of West Bengal ,the MPC+ curve intersected the MPB curve at a quantity . However with the increase in excise tax rates from 20% to 25%, the MPC+ intersects the MPB curve now at a price closer to the price- and a quantity closer to the quantity- as the new excise tax covers up a higher percentage of external cost of consumption of cigarettes in West Bengal, India than the previous excise tax . Thus, government’s intention of increasing excise taxe rate on cigarette consumption in West Bengal to correct the negative externalities of consumption, helps the cigarette market to attain an equilibrium level as close as possible to the social optimum.

Figure 3- Tax incidence on consumers and producers of cigarette

The demand of cigarettes is relatively inelastic (when the percentage change in quantity demanded is lower than the percentage change in price, demand for a good or service is inelastic). With the increase in tax rate, supply curve to shift upwards from S+ to S+ . Thus the new equilibrium becomes price- , quantity- . Area K shows consumer burden and Area Y shows producer burden. The consumer burden is greater the producer burden when the tax rate is increased on the cigarette market by the government and also prices of cigarette would increase further as stated by the “cigarette prices are likely to go up by more than 12%”. Higher consumer burden would cause market demand for cigarettes to contract, causing the cigarette sales volume to drop as implied by the statement- “analysts feel may impact cigarette sales volumes”. Furthermore, as the fall in quantity demanded will be lower in proportion than the increase in price, the government would benefit from higher revenue with the imposition of a higher rate of excise tax.

As a result the consumers of cigarettes would look forward to purchasing cheaper substitutes of cigarettes like bidi, khaini etc. which are “lightly taxed” when compared to the tax rate on cigarettes. The phrase “it accounts for less than 15% of tobacco consumption” expresses that tobacco consumption in other forms apart from cigarette is more popular and with increase in their demand, further negative externalities of consumption would be caused in tobacco market. Moreover, with few producers and consumers ready in exchanging cigarettes at a lower price, parallel markets would be formed as mentioned in the article. In this case, government of West Bengal could implement negative advertisement policies to reduce the demand of cigarettes and thus look forward in trying to correct the negative externalities of its consumption instead of increasing the excise tax rate and experiencing its negative consequences.

Commentary 2

The article discusses the grounds behind the falling economic growth rate (percentage change in the rise in real GDP in an economy over a certain time period) in China. Experts predict that Chinese economy might not meet its expected growth target of 7.5 % in 2013.

Falling growth rate derives from falling AD (aggregate demand- the total quantity of goods and services all the buyers in an economy want to buy over a particular time period, at different possible prices, ceteris paribus) in the economy. Falling AD in the Chinese economy can be attributed to following causes. First, both exports and imports fell from a year earlier, reflecting the slow domestic and overseas demand. Industrial demand of copper from U.K. dropped indicating the reduced copper consumption and falling volume of copper-made products. Comparatively less foreign commodities were purchased, signaling reduced consumer consumption of every-day products. Besides, exports to E.U. and U.S.A. fell. As a result, relatively less foreign currency was earned showing that investments made by the export industry of China fell. Second, bank lending in May has fallen below expectations. With less and less people borrowing money from the banks, investment subsequently fell in most of the sectors of the nation’s economy. With falling investment from industries, falling consumer consumption and net export (value of exports minus the value of imports), AD in the Chinese economy plummeted resulting in lower than expected growth rate in May. This is implied by falling inflation rate (persistent rise in the general prices in an economy over a particular time period).

The following graph illustrates falling aggregate demand by the inward shift of AD curve from (this curve represents the level of aggregate demand before growth rate dropped) to. As a result general price level fell from to causing inflation rate to drop. Inflationary pressure also reduced as represented by falling width of inflationary gap from to .

Figure 1- Consequences of fall in AD

SRAS

0

To tackle the situation, the Chinese central bank might introduce expansionary monetary policy- measure that involves reducing interest rates, intended to increase investment and consumption expenditure in the Chinese economy. If interest rates are lowered, more people will engage in borrowing rather than saving since the returns to the amount borrowed will be comparatively lower. Thus this will lead to increased spending in various sectors of the economy, boosting AD in the process and helping solve the country’s growth rate problem by encouraging rapid economic growth.

The following graph represents the consequences of the central bank’s implementation of expansionary monetary policy. With rising aggregate demand the AD curve will shift rightwards from to. Consequentially, general price level will increase from to causing inflation rate to rise. Also, inflationary pressure will heighten as represented by increasing width of inflationary gap from to .

Figure 2-Effect of implementing expansionary monetary policy

However, rising inflation might create escalating concerns among the authoritative bodies. Infact one of the consequences of the implementation of the easy monetary policy might be the “rise in property prices”, an event that the policymakers have been trying to control ever since the global financial crisis in 2008 when the Chinese government released a 4 trillion yuan package to tackle the problem, causing property bubbles to form consequently.

The most effective solution would be to implement supply side policies- policies which focus on factors aiming to shift the long run aggregate supply (LRAS) to the right, in order to achieve long-term economic growth for “economic restructuring.” As shown in diagram 3, supply side policies cause the LRAS curve to shift outward from to causing the real output level to increase from to and the average price level to reduce from to. Thus, the problem of increasing inflation rate will be solved if this policy is implemented.

Figure 3- Effect of implementing supply side policy

With the aid of supply side policies, the government can improve factors of production. For instance, government can provide better levels of training, vocational education and healthcare services to improve the skills of the labour force. With deregulation and privatization competition will be enhanced, leading to increased productivity. The government can also provide subsidies and grants to promote domestic businesses that will enable them to increase output. However, the opportunity cost involves forgoing other expenditures. The government might also run into budget deficit in the short run. Nonetheless, if the government wants to achieve low inflation rate and high economic growth in the long run, instead of implementing costly short term cooling measures, it should implement supply side policies.

Commentary 3

The article gives an overview of the consequences of the imposition of tariff (taxes imposed on imported goods to protect domestic industries from foreign competition or to raise revenue for the government) on Russian goods by the EU (European Union). Russia has complained to World Trade Organization (an international organization that provides the institutional and legal framework for the trading system that exists between member nations worldwide, responsible for multifarious trade related matters) stating that high tariff has brought detrimental effects to its economy.

Russia claims that EU has imposed high tariff on Russian fertilizers and various steel products. The results of tariff on different stakeholders can be represented by the diagram below-

Figure 1- Effect of tariff imposition by EU on Russian goods

0

Before the tariff was introduced by the EU the average price of the aforementioned Russian goods was . At this price, the domestic suppliers of EU were only prepared to supply only 0 quantity of those goods, whereas the domestic demand of EU citizens was 0 quantity of the goods. The excess demand was thus met importing quantity of goods from Russia. However after the tariff was introduced by EU, the average price of the Russian goods rose from to . As a result, domestic demand contracted from 0 to 0 quantity of goods and the domestic supply expanded from 0 to 0 quantity of goods. So it can be seen that imposition of tariff by EU has caused imports to fall from to .

The domestic producers will better off by increasing the production of those goods which were imported from Russia instead. Thus their revenues will rise from g to g + a + b + c + h. On the other hand, consumers will be worse off by consuming less of those goods at higher prices. The producers of steel products and fertilizers from Russia will be worse off too by exporting lower number of goods at higher prices. Infact their revenues will fall from h + i + j + k to i + j. The loss in revenue amounts to “hundreds of millions of dollars” as mentioned in the extract.

The imposition of high tariff will boost employment in EU to inject more of these goods and services into its economy with the additional benefit of high tariff revenues for the administrative body of EU in form of d + e. However, with rise in price of Russian goods the export industry of Russia will experience huge losses as mentioned above. Thus employment in the export industry will also fall. Side by side, the demand for Russian ruble will fall due to contraction in demand for Russian goods, causing the Russian ruble to depreciate. Russians will then find it more expensive to import goods not only from EU but also from other countries. Thus the rate of economic growth (percentage change in the rise in real GDP in an economy over a certain time period) of Russia will fall.

Thus Russia complained against EU to World Trade Organization (WTO) apprehending an unfavourable future for its economy. WTO has different functions and one of them is to settle trade disputes. WTO has to look into this matter by comparing what Russia is claiming and what the evidences show.

Imposition of high tariff will cause the income distribution of EU to worsen since tariff is a type of regressive tax, burdening people with lower income more than people with higher income. Furthermore, inefficient domestic producers will now produce quantity of goods which were previously provided by efficient Russian producers. Also consumption of Russian goods by EU will fall from to . All these will lead to a deadweight loss of d + f. So the imposition of tariff by will not only lead to global misallocation of resources but will also hurt the consumers of EU. Thus I think such act from EU’s perspective is not completely justified.

It is likely that high tariff was introduced by EU because Russia was benefiting by exporting “cheap energy” sources to the EU market. Introduction of quotas (trade protections which involve setting limits to the quantity of goods that can be imported over a particular period of time) on Russian goods will not be a viable solution since domestic consumers will be hurt by increased prices and decreased consumption. Thus in the long run, the conundrum can be solved when EU signs anti-dumping treaties with Russia through WTO as Russian goods will not experience price hike aiding both the Russian producers and the EU consumers.

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