Taxation Effect on the Individual: Price Elasticity of Demand

The price elasticity of demand measures how much, if at all, a good's demanded quantity depends on a one percent change in price. Therefore, the elasticity of demand also influences to what extent a potential tax on a good might affect the individual and by extension the market. One corner case of elasticity is a price elasticity of demand of zero. This would indicate perfectly inelastic demand, meaning that a change in the price of a good does not invoke any reaction in the consumer's quantity demanded. If this were the case, then whilst a tax would be able to raise revenue and finance the externalities, it would not be able to reduce the amount of meat consumed. Hence it is necessary to confirm that the demand for meat is not perfectly inelastic, as stated in hypothesis 3 (Nicholson, Snyder, Luke, & Wood, 2008, pp. 116-121,129).

Wirsenius et al. (2011), analysed the price elasticities of different foods for the EU27 countries and Säll (2018) also analysed those for Sweden. One can observe the following price elasticities for beef, pork and poultry:

Good Price Elasticity of

Pork -0.80 (inelastic) -0.31 (inelastic)

Poultry -1.00 (unit elastic) -0.34 (inelastic)

Table 3: Price elasticity of demand in the EU27 and Sweden.

One can observe that none of the elasticities equal to zero. This means that in all cases, a price increase would mean a reduction in quantity demanded. The next question is then what the different elasticities mean. According to Nicholson et al. (2008), each percentage change in price induces a percentage change in quantity demanded equal to the price elasticity of demand. Therefore, according to Wirsenius et al. (2011) an increase in the price by 1% would lead to a decrease in the quantity demanded of ruminant meats of 1.3%. For poultry this decrease would be 1%, and for pork 0.8%. In Sweden, the numbers are slightly lower, with elasticity for beef of 0.5, and 0.31 and -0.34 for pork and poultry respectively (Säll, 2018). One can see that the greater the price elasticity of demand, the greater the reaction of consumers to a change in price. In Sweden, the price increase, however, draws out a smaller change than compared to the rest of the EU27 countries. This might be explained due to the high general wealth in Sweden.

However, while the aim is restoring market equilibrium with imposing a tax, the individual may face themselves with a loss of surplus. To visualise a practical example, one can assume meat to be at a fictive price of 40SEK per kilo. In this case, the consumer would be willing to purchase up to 10kg of meat, valuing their tenth kilogram of meat at 40SEK. The consumer would not be willing to consume more meat at that price, as it exceeds his willingness to pay for the eleventh kilogram. However, the consumer receives additional value for every kilogram below the tenth, as they were willing to pay more for it than they had to. This is considered the consumer surplus and is represented in the graph as the area ABC. We can compute the exact amount by calculating the area inside the triangle:

𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 (𝐴𝐵𝐶) = 0.5 ∗ 𝑄 ∗ (𝑃𝑚𝑎𝑥 − 𝑃𝑞) = 0.5 ∗ 10 ∗ (100 − 40) = 300 𝑤ℎ𝑒𝑟𝑒 𝑄 = 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦; 𝑃𝑚𝑎𝑥 = 𝑡ℎ𝑒 𝑚𝑎𝑥𝑖𝑚𝑢𝑚 𝑃𝑟𝑖𝑐𝑒; 𝑃𝑞 = 𝑃𝑟𝑖𝑐𝑒 𝑓𝑜𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 In case of the price of meat increasing, for instance, due to taxation, the consumer would consume less meat, and some of the surplus of the individual would decrease. For this example, a new, fictive price of 80SEK is assumed, reducing this consumer’s quantity demanded to 5kg. Through calculation, we can find the following consumer surplus:

𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 (𝐴𝐷𝐸) = 0.5 ∗ 𝑄 ∗ (𝑃𝑚𝑎𝑥 − 𝑃𝑞) = 0.5 ∗ 5 ∗ (100 − 80) = 50

Figure 9: Consumer surplus and reduction thereof for a fictive case of poultry meat, in case of policy interference.

(Adapted from Nicholson & Snyder, 2008, p.102)

In this fictive case, one can observe a significant loss of the individual's surplus from 300SEK to 50SEK. This is also visually represented in Figure 9. Yet whilst the individual may find their surplus in consuming the good to be decreased, the externalities they create by consuming the good are also being reduced. This will further be discussed in the next chapter.

As established, a tax interference is likely to raise prices, and hence will reduce the individual’s quantity demanded. Furthermore, it decreases their consumer surplus. But it also has the potential to interfere with the market equilibrium and welfare and can create a deadweight loss. Ultimately, a tax will shift either demand or supply, and result in a new market equilibrium at a lower quantity demanded/supplied and at a higher price for the consumer, and a lower price for the producer. Figure 10 below (Kutasi & Perger, 2015) illustrates the shift created by taxation and the associated deadweight loss created.

A deadweight loss arises where some consumers and suppliers would be willing to engage in mutually beneficial exchange, were it not for the tax present. Furthermore, this potential revenue is also not received by the tax imposing authorities (Nicholson &

Snyder, 2010, pp. 330-331; Abadie, Galarraga, Milford, & Gustavsen, 2015).

10 kg

Figure 10: The effects of taxation on welfare. (Adapted from Nicholson & Snyder, 2010, p 578 & Kutasi & Perger, 2015)

Bishai (2015) goes a step further and argues that different tax (and subsidy) combinations can create different scenarios, some which may increase and others which may reduce consumer welfare. With a low deadweight loss from taxation and the assumption that a given Nutrient B is superior to a given Nutrient A (for instance by being healthier and causing fewer CHD-cases), a tax and subsidy policy combination may even benefit the consumer. They also argue that should the deadweight loss be bigger than its potential benefits, a nutrient tax will eventually fail (Bishai, 2015).

Figure 11: The effect of taxation with different DWL scenarios. (Bishai, 2015)

In the specific case scenario analysis of imposing consumption taxes in Denmark based on emission levels, Edjabou and Smed (2013) did indeed find a reduction of consumer surplus, between ~350 or ~1000 DKK per person per year. However, this study did not

Tax = Externality

Q Q‘

S = MC S‘ = MC‘

D P

P‘

Price Cost

Quantity (output) DWL

take into account the health and utility benefit obtained by living in a cleaner environment or having lower health care cost and time spent at the doctor or in pain (Edjabou & Smed, 2013). This is also the argument of Kutasi and Perger (2015) concerning a potential fat tax: "the fat tax may increase the consumers’ welfare if the amount they are willing to pay for one unit of loss from excess weight is higher than the ratio between the amount paid for taxable products and the excess weight lost because of the tax.” Hence, a tax eliminating externalities may have a chance to increase the welfare of the consumers and ultimately total welfare.

Not only consumers but also the supply side may be affected by a change in welfare.

When prices rise, and quantities demanded fall, producers will likely have to decrease production (Säll, 2018). When Mexico implemented a (high) calorie tax, they took care to analyse the potential adverse effects such a tax could have on the economy. They concluded that the benefits of such a tax would surpass the deficits, however, in their specific case (Kutasi & Perger, 2015).

To minimise deadweight loss, Caro et al. (2017) state that "theoretically, the combination of food taxes and subsidies can have larger impacts on average household purchases while minimising welfare losses, relative to a tax only scenario." Other research confirms that finding, and further states that it can also help governments promote certain nutrients that would be recommended for a healthy, wholesome diet (Abadie, Galarraga, Milford, & Gustavsen, 2015). Therefore, in an optimal scenario, not only a tax but also a subsidy would be implemented. On another note, should the tax manage to eliminate the externality to a point where its revenue is lost, the imposing agency (the government) could potentially run into a funding problem for the subsidy (Kutasi & Perger, 2015).

The most significant area of concern identified with taxing foods specifically, is that of regressivity. Previous research concluded that in general, food taxes tend to be regressive, because overall the less affluent will spend a higher proportion of their money on foods than the richer. The fact, that usually unhealthful food is taxed, heightens this effect which again is consumed in higher proportion by the poor (Muller, Lacroix, Lusk, & Ruffieux, 2016). In a French study investigating an animal product-based food tax, Caillavet et al. (2019) found an approximately one percentage higher loss in purchasing power for poorer households (5.84-9.25%), as compared to the richer ones (4.53-7.74%). Säll (2018) investigated the compensation variety needed to keep

households’ utilities at the same level before and after introducing an environmentally motivated food tax. She concluded that lower-income households would require higher compensation relative to their income levels than higher-income ones. Kerkhof et al.

used the Gini Coefficient to evaluate an emission tax in the Netherlands. The Gini Coefficient is a common measure of income inequality, where the higher it is, the bigger disparity is amongst the population. Here, it increased by 0.4% with the introduction of a CO2 tax, and a GHG tax was likely to raise it by 0.11 points. Similar results have been researched and found in Denmark and the UK (Caillavet, Fadhuile, & Nichele, 2019).

However, Muller et al. (2016) also argued that “price regressivity does not necessarily imply health regressivity.” Instead, if such a tax can motivate people to become healthier and enjoy a more prosperous, more fulfilling life due to dietary and environmental improvement, such a tax may still be justified.

Attention needs also be given to the risk of double taxation. When computing a new consumption tax, existing taxes have to be taken into account. The danger of double taxation is to create too high a cost and create artificial inefficiencies. Furthermore, any tax comes with the cost of computing the tax as well as controlling it. These transaction costs need to be funded and also be seen as an inefficiency (Gren, Moberg, Säll, &

Röös, 2019). As Kutasi and Perger (2015) state, a miscalculated tax and flawed implementation can even invalidate a (Pigouvian) tax.