Significance of PED with Indirect Taxes

In this revision video we look at an answer to this question: "Examine the significance of PED for a government in relation to indirect taxes."

Examine the significance of PED for a government in relation to indirect taxes

Analysis Point 1

Governments often levy indirect taxes on suppliers of products such as alcohol, tobacco, gambling and high sugar foods and drinks.

If the PED is low, for example, the coefficient of PED = (-) 0.3, then indirect taxes will have relatively limited effects on quantity bought.

But if demand is not price sensitive, then an indirect tax can expect to raise substantial tax revenues for the government.

So, if the priority for a government is to maximise tax revenues, they should tax goods and services where demand is price inelastic

Evaluation of Point 1

However, higher prices caused by the tax might encourage tax evasion for example, through imports of counterfeit products.

This can then negate the impact of a tax on revenue and perhaps lead to external costs if counterfeit products are dangerous when bought.

Analysis Point 2

If an indirect tax is imposed on a product with a price elastic demand, then we expect to see a significant contraction in demand.

For example, if a tax raises price by 20% and the coefficient of PED = (-) 2, then demand would contract by 40%.

Indirect taxes can prove effective in lowering demand / consumption when this is one of the aims of government intervention.

An example might be the introduction of the tax on high-sugar drinks brought into England a few years ago.

A study published in the BMJ found people in the UK were buying and consuming less sugar from soft drinks since the UK introduced a tax on sugary drinks.

Evaluation of Point 2

However, some may have shifted to other products with high sugar content making the tax less effective in improving health outcomes.