Benefits of using indirect tax as a solution to demerit goods and negative externalities
Indirect tax is a suitable solution to tackle negative externalities as it enables a decrease in production for polluting firms. By accepting the polluter pays principle, which explains that firms who are responsible for polluting the environment should pay the price for the damage they create. An indirect tax will involve the manipulation of the market as the cost of production for firms will increase. The likely consequences of this will be an inwards shift of quantity supplied. This is beneficial when acting as a pollutant tax as it will decrease the negative externalities that production entails. These effects can be demonstrated on the negative externalities of the production diagram. The increase in the cost of production will diminish the social cost and therefore limit the welfare loss caused by pollution. This will be beneficial as it directly tackles the pollution problem and internalising the externality through taxation.
A tax will cause MSC to decrease and therefore the negative externalities will be limited indicated by a smaller welfare loss triangle making this tax a suitable solution as by forcing a decrease in MSC, the negative externalities will be internalised. The imposition of a tax essentially raises the cost of production. This causes, cp, the firm to supply less at any given price. This takes the market closer to the social optimum where MSC = MSB.
Indirect tax can be an efficient solution to limiting negative externalities and demerit goods as tax revenue can be used to promote positive externalities. By taxing firms that pollute, the capital that is collected can be directed towards funding environmentally friendly schemes. The government can subsidise solar panel production which will encourage green living. This subsidy will make production cheaper and therefore more will be produced. For consumers the price of solar panels will be cheaper which encourages purchasing them as they will be a better solution to gas or petrol as they may be cheaper. This subsidy will be able to increase positive externalities which will have a great effect in improving the environment. Through solar panels, not only will environmentally friendly alternatives be consumed but they will also become more aware and which could turn into a trend. This will encourage greater demand and therefore this will be an effective solution to limit negative externalities and promote positive externalities.
