Why are demerit goods subject to such heavy indirect taxes?

 

Indirect taxes are taxes which are levied on producers by the government, part or all of which the producer can choose to pass on to the consumer. If the consumer is price sensitive, the producer will absorb the part of the tax which enters the producer’s previous producer surplus and pass on the part that is within the pre-tax consumer surplus. In situations where the consumer’s demand is completely elastic, the producer will absorb the full cost.  

 

The qualities of demerit goods make them attractive for the imposition of indirect taxes. A demerit good is something that is acknowledged to be, on balance, bad for society and for individuals. The demerit good imposes costs upon third parties, society in general, and possibly users with imperfect information. These negative externalities mean that the private market price and the optimum social price, once social marginal cost is considered are different. Overall, the market will oversupply and under-price a demerit good relative to its optimum social price and supply.

 

Demerit goods or services are typically either addictive or in some way create a dependency, which makes users inelastic in demand. They also stretch across income groups, and therefore have a low-income inelasticity of demand, though as with all things, the rich probably have more scope to ‘kick’ dependency or are more insulated from its costs than the poor. Suppliers are sensitive to price, however, so they will produce far more than the social optimum if costs are low. 

 

Governments, sometimes under political pressure, are often keen to suppress or minimise demerit goods. For example, tobacco, alcohol, guns, pornography, petrol, fatty foods, and sugary drinks, all impose costs on society and can be detrimental to users in ways that the users can neither predict nor control. This can lead to healthcare, policing, infrastructure, and public order costs, and to a loss of productivity. If use of the goods or services results in a loss of disposable income, people can become more reliant on inferior goods, and tolerant of poor living standards.

Such developments can have a negative effect on the capacity of the economy to provide and grow and might also create a large class of structurally unemployed, or simply unemployable, people.  They could also lead to the development of monopolies or oligopolies which extracted money from users and displaced legitimate businesses.  

 

An indirect tax will ‘punish’ producers, lower output, and raise costs for a demerit good or service. This will have the effect of discouraging use and of providing tax revenues to pay for elimination or rehabilitation programmes. It is therefore a better option than, for instance, prohibition, which involves great government prohibition and interdiction costs and no revenue. A government should only turn to prohibition if the opportunity cost of toleration and regulation, in terms of the damage done to individuals and society, is too great, or if the psychological threat from prohibition policing to supplier reputation and peace of mind is so great that suppliers leave the market.  

 

Not all demerit goods are the same, and demerit goods often have some positive as well as negative externalities. The criteria by which they are judged is important. In a free society and a free market, individuals do have the right to take, do, or say things of which others do not approve. Disapproval is not a material externality.

In addition, the exercise of free choice over one’s body, after the provision of information, should not be answered with the comment that healthcare costs might be imposed by smoking, overeating, or drink, because smokers, overeaters and drinkers invariably contribute more by taxes and purchases to the national budget and economy than they consume.

The claim that informed adult people should be regulated and taxed for their own good infantilises individuals and is an argument for a centrally directed and planned economy. Planned economies are generally neither more efficient nor more productive than free markets. 

 

One distinct reason for which governments and populations are keen to impose indirect taxes is environmental. Green taxes such as differential excise taxes on motor vehicles depending on the size of their engines, value added taxes (VAT) and excise duty on fuel, and green levies on electricity use by providers of electric charging stations are all geared to paying for or restraining the problems caused by transport.

The principal problem caused by transport is emissions and air pollution, followed by the death toll from accidents, and the destruction of paths, city centres, public health, and the countryside by roads and chemically powered vehicles on them. Even then, however, different types of transport carry different costs and benefits with them; the efficient delivery of freight across the country is less damaging, for instance, than driving noise polluting motorcycles or petrol- and diesel-hungry utility vehicles around towns. Air travel might be amore efficient and effective way to allow tourism, on which many countries depend, to flourish than dependency on trains, cruise ships, and ferries, for example. 

 

Governments in recent years have eschewed ‘one size fits all’ indirect taxes in favour of policies which might encourage a voluntary modal shift. For instance, ultra-low emissions zones and congestion charges, which are direct taxes, and the mass provision of subsidised city bikes, might be more effective in promoting cycling, walking, or the use of public transport, than indirect taxes are.  

 

It is also the case that indirect taxes still need to correspond to Smith’s canons of taxation. They must be accepted as fair, proportionate, easy to assess, and easy to collect, and must not cost more than they produce. This is not ideological but practical; taxes that are too expensive to levy or collect, or which pay no attention to the rest of the tax burden on consumer income and therefore become regressive, will be avoided or evaded.

A ‘Pigouvian’ tax which focusses on ‘internalising’ the marginal externality caused by an activity or sale will also be very difficult to calculate. Since tax revenue is generally not hypothecated, the suspicion must also exist that the principle of environmental taxation is just the principle of taxation extending on a convenient basis to more and more things. 

 

Many of the problems that environmental taxes speak to would be better dealt with by, for instance, greenbelt legislation or, as in the case of petrol cars, will be displaced ultimately by technology. Often, the activity involved will be socially necessary.  Even in an era of working from home, transport is still important, if not more necessary for mental health and those workers who must move and who are not provided with good public transport options which meet with their shift requirements. 

 

With demerit goods, governments must decide if they wish to reduce expenditure or simply to switch it elsewhere. A better approach than taxing would begin with an integrated policy in which governments laid out all the costs and benefits, looked at items within the context of the whole economy, and sought to minimise externalities by avoiding or shifting the reasons they arose rather than simply taxing them. Moral hazard is also a danger with any forms of ‘sin tax’ (especially if it is simply a tax under cover of virtue-signalling rather than sin reduction.)  

 

For instance, transport produces around between 25 and 30 per cent of all UK carbon dioxide and pollutant emissions. Road transport is 90 per cent of all those emissions. 30 per is goods vehicles and light vans. Increases in taxation on petrol cars, and the way life has been made harder for their drivers over the past two decades, have reduced their emission of greenhouse gases by 90 per cent, but this is balanced by a 250% increase in the emissions from diesel cars. Air pollution has also rose by fifteen percent in the ten years to 2010 and has risen slightly since. Judging from 1970, however, emissions of carbon dioxide, nitrogen dioxide, sulphur, and methane, have fallen so significantly that they can be said to have collapsed.  

 

Transport costs, from cars and aviation, are in part an effect of the economy. A boom will increase them; large amounts of internal migration from air flights, and cheap flights home again for many migrants, increase them.  The UK is now entering a period of higher prices, lower disposable income, and lower or negative post-Brexit migration.

It is not inconceivable that doing nothing, which is to say not adding any new taxes to the economy, will still be accompanied by falls in greenhouse gas pollution and in the purchases of many demerit goods.  

 

In other countries, taxing fatty foods has not proven to be possible without government failure. In Denmark, for instance, attempting to tax food resulted in a cross-border boom in bulk sales with Germany, and it is perfectly possible, given the internet and the common travel area, that similar things could happen across the internal Irish border and the eurotunnel.  

 

The case that indirect taxes are the best way to deal with externalities, or that they work almost anywhere as well as alternative policies such as subsidies, is not robust. The fact that they bring in tens of billions, in the form of VAT and excise taxes, to a treasury which refuses to tax assets, share dividends, or high-income earners, is unarguable.

 

An effective strategy for the Treasury might be to switch towards direct taxation of higher income earners and asset holders. This could be accompanied by an attempt to address housing problems. These are obesogenic because they leave large numbers of people with low disposable incomes after rent, no chance of purchasing a home or paying off debt, and every incentive to sit at home eating comfort food. All of these things are externalities of the current housing market. They are not helped by indirect taxation. It is evident that government is not keen to tax items with negative externalities that have positive income elasticities such as high rents, expensive kitchen knives, or second homes.  

 

It follows that the present taxation of demerit goods might, not wholly but to a persuasive extent, be seen as a form of socially conditioned regulation and taxation which is convenient because of elasticities rather than emerging from a consistent approach to externalities.