VAT Worksheet - VAT - Taxing externalities

This worksheet deals with how indirect tax changes may be used to try to take account of externalities in the consumption of various goods to ensure that the optimum quantity of a good is consumed.

There is also a printable version of this worksheet available for classroom or personal use with spaces to fill in the answers.

Step 1 - The defining moment

Find out and write down definitions for the terms below. To help you in this, you may want to use the VAT theory section and the glossary of the Virtual Economy. You can access these from the side panel or the navigation bar at the top of the page.

Indirect taxes

Positive externalities

Negative externalities

Consumption externalities

Production externalities

In the table below, we have given one example of each type of externality. See if you can add two more examples of each:

Consumption externalities		Production externalities
Positive	Negative	Positive	Negative
The benefits to the rest of society of people being vaccinated before travelling abroad	Noise pollution from people playing loud music in public places	The benefits to the environment that arise from the planting of woodland by a forestry company	Waste products being dumped into a river by a company
1...	1...	1...	1...
2...	2...	2...	2...

Step 2 - Taxing it

(N.B. This step is the same as Step 2 in VAT worksheet 1, so if you have already done this you may want to skip to Step 3)

Use either your course materials or the resources available in the Virtual Economy to help you find out about all the indirect taxes that we have in the UK. Use this information to fill in the blanks in the table below. You may find the explanation of VAT and the input form of the model helpful in doing this.

Product?	Price?	Total tax?	Tax as a % of price?	Tax collected by?
Petrol
		718.8p		HM Customs & Excise
			29.8	HM Customs & Excise
Wine
	336p

Why does the government change the level of the per-unit taxes in each Budget, but not that of the ad-valorem ones?

Step 3 - Externalities? What externalities?

As it we have seen in Step 2, the government taxes a variety of products. Clearly it does this to raise revenue, but it may also do it because there are external costs that arise from the consumption of these goods. Without a tax, there may then be over-consumption of these goods as they appear too cheap and people do not take account of the external costs of their actions.

In the table below, fill in examples of external costs (or benefits) that may arise from consumption or production of the good given. We have started off with one example; fill in as many more as you can for each good:

Product	Example of externality?	Type of externality?
		Consumption or production?	Positive or negative?
Alcoholic drinks	1...Drunkenness causing anti-social behaviour and requiring police action
	2...
	3...
Petrol	1...Congestion caused by large amounts of traffic
	2...
	3...
Cigarettes	1...Smoking in public places creating the health problems associated with 'passive smoking'
	2...
	3...

Step 4 - Taxing it up

It is the presence of external costs, as we have seen above, that may cause the government to tax some goods. The tax should therefore be equivalent to the external costs to ensure that the optimum amount for society is consumed.

If the government misjudges the level of external costs and puts a tax on the good that is too high, will the amount consumed be above or below the social optimum?

If the amount of the tax is too low, will the amount consumed be above or below the social optimum?

On the diagrams, below we have shown the levels of private cost (MC) and of social cost (MSC - private costs + external costs). Draw in an additional line to show the amount of the tax for the two possibilities above - first when the tax is too high (greater than the external costs) and second when the tax is too low (less than the external costs):

1...The tax levied is greater than the external costs

2...The tax levied is less than the external costs

Step 5 - Taxing it up in the real world

In practice, there are many other factors that affect the level of indirect taxes imposed by the government - not least that it needs to raise revenue to pay for public services. Changing the level of indirect taxes will also have significant effects on the economy.

Let's say that the government feels that it has set indirect taxes too low to account for the level of external costs, and so decides to increase them significantly. Go to the model and try this policy out. Increase indirect taxes on:

• Petrol because of growing congestion problems (a substantial increase)
• Cigarettes because of the increasing health costs
• Alcohol because of increased consumption causing health problems

What effect has this had on the economy? Note the changes down in the table below:

	1999		2000		2001		2004
	Before change	After change	Before change	After change	Before change	After change	Before change	After change
Inflation (%)
Unemployment (% of work-force)
Economic growth (GDP growth) (%)
PSNCR (£bn)

What about individual families in the economy? How have they fared? Note down in the table below the change in income they have had and calculate the gains or losses shown in the next two columns:

Which family has lost the most as a percentage of their income?

Which family has lost the least as a percentage of their income?

What disadvantages of using indirect taxes in this way are evident from the data above?

What advantages are there to this policy of increasing indirect taxes to reflect the level of external costs?