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Effects of Increased Excise Taxes

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.

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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



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


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

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