The main disadvantage of using tax is that in order to make the marginal private cost equal to the marginal social cost, one must know the difference between the two in numerical terms, and this is often extremely difficult to do. The marginal social cost of cigarettes may be, among other things, cancer. The government setting a tax must calculate the cost in monetary terms, and this is nearly impossible to quantify.
If the government places too high a tax, it would be inefficient because it would lead to an under provision of cigarettes. If the tax is not large enough to shift the marginal private cost sufficiently to the left, then there will still be too many cigarettes because the cost will not be fully internalised.
In addition, most taxes are not continuous and are not linked to the amount of cigarettes produced or the amount of pollution released. This means that a one-off tax may have little long-term effect.
The advantages of tax are clear: if the amount of tax levied is correct, then they are an easy and simple way to internalise the costs.
However, the effectiveness of any tax also depends upon the price elasticity of the good in question: cigarettes, primarily because of influence of habit and also because of the lack of any close or viable substitutes, are relatively price inelastic. This means that if the government levied a tax on a tobacco company, the increase in costs could be passed on to the consumer in the form of higher prices.
The company would not lower production of cigarettes enough to cover the externality, and there would still be market failure. Higher taxes may then have an inflationary effect on the economy if producers do choose to pass on the costs.
The main disadvantage of using tax is that in order to make the marginal private cost equal to the marginal social cost, one must know the difference between the two in numerical terms, and this is often extremely difficult to do. The marginal social cost of cigarettes may be, among other things, cancer. The government setting a tax must calculate the cost in monetary terms, and this is nearly impossible to quantify.If the government places too high a tax, it would be inefficient because it would lead to an under provision of cigarettes. If the tax is not large enough to shift the marginal private cost sufficiently to the left, then there will still be too many cigarettes because the cost will not be fully internalised.In addition, most taxes are not continuous and are not linked to the amount of cigarettes produced or the amount of pollution released. This means that a one-off tax may have little long-term effect.The advantages of tax are clear: if the amount of tax levied is correct, then they are an easy and simple way to internalise the costs.However, the effectiveness of any tax also depends upon the price elasticity of the good in question: cigarettes, primarily because of influence of habit and also because of the lack of any close or viable substitutes, are relatively price inelastic. This means that if the government levied a tax on a tobacco company, the increase in costs could be passed on to the consumer in the form of higher prices.The company would not lower production of cigarettes enough to cover the externality, and there would still be market failure. Higher taxes may then have an inflationary effect on the economy if producers do choose to pass on the costs.
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