Taxes: a) Based on the information provided, advise the Minister which one of the two products she should tax. Explain and justify your advice. Taxation is one source of government revenue, there exist two types of taxes which are direct taxes and indirect taxes, direct taxes are those taxes that are imposed directly on products or even personal income tax. Indirect taxes are taxes imposed on good and services. When a direct tax is imposed then both the sellers of the products and the buyer faces the burden of tax. On the decision to decide which product to impose the tax we will have to consider the incidence of tax and this will be determined by the elasticity of demand.
Because the country has no indirect tax then that’s why the indirect tax is preferred, the effect of an indirect tax on a good is demonstrated below: When the tax is imposed on the seller then the price rises and this is shown in the diagram where the price moves from P to P+T, these price increase shift the supply curve upwards from supply curve 1 to supply curve 2 as shown above.
When we have perfect inelastic demand curve then the tax burden is wholly transferred to the buyer, however if we have perfect elastic demand curve then the tax burden is to the seller or producer. Concerning supply when we have perfect inelastic supply curve then the tax burden is to the seller, and when we have a perfect elastic supply curve then the tax burden is to the buyer. A tax will lead to a reduction in the producer surplus and at the same time the consumer surplus, further the tax also results to dead weight loss, the diagram below shows the consumer surplus and the producer surplus: From the above diagram it is clear that the producer surplus is reduced and also the consumer surplus, the loss in consumer surplus and producer surplus goes to the tax and also the dead weight loss.
Therefore a tax will lead to a loss which is referred to as the dead weight loss. The dead weight loss is the value that is lost as producer surplus and consumer surplus and also it is not collected by the government as tax. In our case we have two good to consider: bilos and cigarettes, the elasticity of demand for bilos is 2.00, while for the cigarettes the price elasticity of demand is equal to 0.05.
Given the elasticity levels then it is clear that bilos have a higher elasticity level and this means that a change in their prices by imposing a tax will reduce the demand by a very large quantity. For the cigarettes the elasticity level is lower and therefore an increase in price will not reduce demand by a large margin.
The diagrams below show the effect of a tax on the two goods: From the above diagram it is clear that when the tax is imposed on either of the goods the level of price will raise and the supply curve shifts upward, the diagram assumes that the price for both goods is equal and that the tax imposed increases the price to the same level.