a) Based on the information provided, advise the Minister which one of the two products she should tax. Explain and justify your advice.

Taxation is one source of government revenue, there exist two types of taxes which are direct taxes and indirect taxes, direct taxes are those taxes that are imposed directly on products or even personal income tax. Indirect taxes are taxes imposed on good and services. When a direct tax is imposed then both the sellers of the products and the buyer faces the burden of tax.

On the decision to decide which product to impose the tax we will have to consider the incidence of tax and this will be determined by the elasticity of demand. Because the country has no indirect tax then that’s why the indirect tax is preferred, the effect of an indirect tax on a good is demonstrated below:

When the tax is imposed on the seller then the price rises and this is shown in the diagram where the price moves from P to P+T, these price increase shift the supply curve upwards from supply curve 1 to supply curve 2 as shown above.

A tax will lead to a reduction in the producer surplus and at the same time the consumer surplus, further the tax also results to dead weight loss, the diagram below shows the consumer surplus and the producer surplus:

From the above diagram it is clear that the producer surplus is reduced and also the consumer


surplus, the loss in consumer surplus and producer surplus goes to the tax and also the dead weight loss. Therefore a tax will lead to a loss which is referred to as the dead weight loss.

In our case we have two good to consider: bilos and cigarettes, the elasticity of demand for bilos is 2.00, while for the cigarettes the price elasticity of demand is equal to 0.05. Given the elasticity levels then it is clear that bilos have a higher elasticity level and this means that a change in their prices by imposing a tax will reduce the demand by a very large quantity. For the cigarettes the elasticity level is lower and therefore an increase in price will not reduce demand by a large margin. The diagrams below show the effect of a tax on the two goods:

From the above diagram it is clear that when the tax is imposed on either of the goods the level of price will raise and the supply curve shifts upward, the diagram assumes that the price for both goods is equal and that the tax imposed increases the price to the same level.

The demand curve bilos is elastic while that of cigarettes is inelastic, therefore if we choose the bilos to impose the tax the incidence of tax is that the burden will be both to the producer and the customers, however if we choose the cigarettes the greatest burden will be on the buyers.

The best option therefore will be to impose a tax on cigarettes. Cigarettes are luxuries as compared to the bilos which are more productive. The other reason why we would choose the cigarettes is that a price increase will not affect the demand for them by a greater degree as compared to the bilos.

The other reason is the issue of incidence of tax, for the cigarettes the greater tax burden is to the buyers and for this reason we will achieve higher revenue without affecting the demand in the market. For healthy issues this tax imposed on cigarettes will be viewed as a way in which


we are discouraging people to smoke and therefore the decision to impose tax on cigarettes will not be viewed negatively by the population.

Further the dead weight loss in the cigarettes is lower than the loss in the Bilos tax. Therefore it would be advisable to tax the cigarettes instead of the Bilos. For these reason therefore the proportion of tax collected with regard to the decline in producer and consumer surplus is higher than when the Bilos are taxed, this is because the dead weight loss when we tax the Bilos is higher than when we tax the cigarettes.

b) The decision to impose the indirect tax may still be unpopular with consumers and/or suppliers, depending on which product is taxed; the Minister needs to be prepared for any potential negative political reaction. For both products, advise the Minister where potential negative reaction to the tax may come from.

The decision to impose taxes on products may result to negative reactions, when taxes are imposed on a product it is likely that the products demand decreases and as a result the profits obtained by the producers of these products will decline due to low demand that leads to low sales.

Tax on Bilos:

Bilos are used in almost all offices, schools and colleges, an increase in their price will lead to a negative reaction by almost the entire population because every other person uses and purchases Bilos. As a result of the tax on Bilos therefore the whole population will term this tax as unpopular.


The other negative reaction will come from the producers of the Bilos, the producers will experience a decline in sales level and therefore they will record lower profits. The lower profits will lead to the companies wanting to cut off on expenses by laying off workers, therefore in this case there will be a negative reaction that will result from the companies and also the laid off workers from these companies as a cost reduction measure.

The other issue is that Bilos, papers and books are complementary goods, when the price of Bilos rise and their demand rise it is highly likely that the demand for its complementary will also decline. For this reason therefore there will be a negative reaction coming from the producers of books and papers regarding this tax. The decline in demand for papers and books will lead to a decline in the profits for the producers of these products and as a result there will be a rise in unemployment as a result of the increased lay off of these companies wanting to cut on the cost of production in order to maintain high profits.

Tax on cigarettes:

When taxes are imposed on cigarettes the prices will rise, however because the elasticity of demand in this case is low the demand will not decline at the same rate as that for the Bilos, therefore the prices will rise and demand will fall, smokers will react to the price increase while in the same case the producers will experience a decline in profit and therefore they will still have a negative reaction to the tax.

Unemployment will rise and therefore this will be an unpopular tax imposition by the government, the unemployment will be caused by the cigarette producing companies whereby they will lay off workers in order to maintain high profits whereby they will try to reduce the costs of production.


The other issue regarding cigarette tax is that the taxes will only target a certain group in the economy, this target group is the smokers, this may be a tax that will target this group of consumers only and the taxes produced will result to the free rider effect. This means that the revenue collected will be used to provide public goods to the population but some of the people who enjoy the goods will not have paid for the taxes. Therefore the free rider effect on the economy will lead to negative reaction form the target group.

A positive reaction however will come from non smokers who advocate for a tobacco free economy, the increase in prices of cigarettes will lead to a decline in the number of cigarettes produced in the economy, as a result of this therefore there will be a decline in the diseases associated with smoking and also some smokers will stop the habit, therefore the tax on cigarettes will lead to positive vote regarding the health and health expenses on the diseases and ailments caused by smoking.


It is clear that an indirect tax is a source of government revenue. However the decision on what product to tax must be determined with the consideration of reaction from the suppliers or the buyers. The government has therefore to consider the incidence of tax or in other words whether the seller or the buyer bears the tax burden.

In our case it is better to tax to tax cigarettes because they have a lower elasticity of demand and therefore the price increase will not lead to a large decline in demand than in the case of Bilos. The tax burden when cigarettes are taxes is largely to the buyers.

However in both cases there is a possibility of negative reaction by both the buyers and the


sellers, this is because they both bear the tax burden that is imposed, however negative reactions when cigarettes are taxed is less than in the case when Bilos are taxed.