Drawbacks of using indirect tax as a solution to demerit goods and negative externalities

Indirect tax may not be the best as production of polluting goods may be necessary for employment and maintaining output. The production of goods including cars can create pollution and therefore negative externalities, however they provide employment and cars are essential to modern day living. Therefore, the cost of limiting the production of cars will be at a greater cost than limiting pollution. A tax on the production of production that incurs pollution will limit the output of firms. The effect of this will be a decrease in revenue and therefore will force firms to let go of staff. This will increase unemployment which will have a greater effect on the total economy depending on the size of the market, in * this case the car market is enormous so this could have a substantial effect. Furthermore, less cars will be produced, even though pollution will fall, cars are needed for transport. As this will be hindered, workers may not be able to work efficiently and productively as they may be able to access work as they live too far from their offices. This means that the economy will be working inefficiently which can be illustrated on a PPF diagram. Therefore, tax may not be the best solution as it will limit positive externalities and increase unemployment.

Indirect tax may not be the most effective solution to limit consumption of demerit goods as demand is highly dependent on its price elasticity. An alcohol tax may be ineffective as demand for alcohol is inelastic. This is because alcohol can become addictive and for alcoholics they will view consumption as a necessity. It also only takes up a small % of incomes as prices for most are low. Therefore demand will not drastically change through a change in price. Price elasticity of demand refers to how responsive demand is to a change in price, and if demand is inelastic, an increase in price through tax will lead to a less than proportional fall in quantity demanded. Therefore, an indirect tax will not limit consumption of alcohol and therefore will be ineffective in reducing the demand for demerit goods. This is damaging as demerit goods cause negative impacts on consumers so indirect tax will not be a solution to this market failure. But it will thus allow for a lot of revenue to be collected.

Taxing demerit goods is ineffective as demand for them is often inelastic so the market failures will not be solved as consumption will not experience a substantial impact.