Discussion of the Incidence of Tax on Luxury Cars - Example

Introduction The paper shall look at the laws of supply and demand as applied to three major categories i.e. price ceilings, positive externalities and taxes on luxury vehicles. The arguments will be based on case studies within the country and the results produced by them. Possible solutions to prevent market failures in each of the three categories will also be given. PART A- price ceilings Why governments impose price ceilings in a competitive market with illustration of its effects on a diagram Price ceilings are defined as a maximum price that a government sets in order to ensure that market prices do not exceed a certain amount. Usually, these maximum prices are set for suppliers. Their effectiveness depends on a selection of an amount that must be less than the free market price. There are a series of conditions that may necessitate the adoption of a price ceiling. For instance, in the event that an essential commodity’s price increases, then such a measure may be necessary. Examples her include rent caps that exist in certain parts of the world such as in New York - USA. In other countries like the Ukraine, their governments have imposed price ceilings on gas prices. In other scenarios, countries have placed price ceilings on doctor’s fees. (Henderson, 2006) In order to understand how the price ceiling works, it is imperative to study the diagram below. It is a graph of price against quantity of goods sold Price Pe Pmax Pceiling Q2 Q1 Quantity of goods A price ceiling must entail sound judgment on what this chosen price should be. Assuming that the price of a commodity without any government intervention is Pe, then a government introduces a ceiling price Pmax; such a move would create an excessive demand for the commodity from consumers represented by Q1 yet suppliers can only offer a quantity of goods corresponding to Q2. This eventually leads to consumer surplus that emanates out of the existence of a higher demand (represented by the arrow in the diagram above) usually because the quantity of goods supplied is lower. Additionally, there is also a producer surplus that results when suppliers offer less than they would have in a free market. When producer and consumer surpluses exist, then these total sums are known as dead weight losses. (Gills, 2008) Most often than not, a price ceiling may create effects that had not been intended. For instance, it may lead to rationing in case of market shortage. Here, suppliers may sell goods only to those individuals who report first or to those consumers that they know which leads to inequity. In other scenarios, it may result in the existence of a black market where commodities are sold at a higher price than the price ceiling. Also, a price ceiling makes suppliers adjust their supply i.e. making the supply curve elastic. Case study of where price ceilings have been used and why the price ceiling was thought to be necessary An illustration of where the government applied price ceilings is within the housing sector during the nineteen eighties. At that time, the government sought to control the excessive increases in house costs while at the same time attempting to boost growth of this sector. It was anticipated that setting a maximum price would have protected consumers from unfair treatment by their landlords. In other words, this was a mode of consumer protection. It was also estimated that the housing market had not yet grown sufficiently to operate without any form of regulation. In fact, the government treated it as a market in which imperfect competition existed. It was stated that the laws of competition were not applicable because there were some elements of monopoly within the market. Consequently, the UK government thought it necessary to set price ceilings for rent prices in order to curb such tendencies. (Henderson, 2006) Results of the government intervention As economists had predicted, these interventions eventually led to unexpected outcomes. In the short term, there were fewer houses that were available for rent. This meant that there was a temporary shortage. However, not all landlords reacted in this manner. In fact, housing quality began deteriorating thus leading to unmet consumer needs. The latter case arose out of a need for landlords to save as much money as they could in spite of the prevailing market conditions. This meant that the net outcome was much lower and that the price ceiling was not an effective measure. In the long term, certain landlords felt that they could not yield sufficient profits while operating within the price ceiling limit. Consequently, some of them opted to get out of the housing market altogether thus creating double loss for both concerned parties. Suggestions on better ways of dealing with the issue It would have been better if the government opted to grow the housing market rather than to create an artificial equilibrium within the market. This is largely because the former mentioned approach would have addressed the existing problem within the housing market more directly than the latter one. There are several ways in which this could have been done. For instance, the government would have chosen to offer grants to land developers who belong to a housing association. Alternatively, it would have chosen to implement tax incentives for housing properties. These two mechanisms would have generated more gains than losses to the housing industry and to the economy as a whole. For instance, while the government would have to use taxpayers money to service the intervention, the same taxpayer would have benefitted from a larger supply of housing and thus lower pricing. In other words, these latter interventions would have made consumer demand elastic and long term benefits would emanate from the approach. (Smith, 2002) PART B – positive externality Why government intervention is often required if there is a positive externality in the market and illustration of its effects on a diagram A positive externality is that extra benefit that emanates from production of a good or service to another industry or business that is not directly related to the business that produced the externality in the first place. Positive externalities may necessitate government intervention after the good/ service has been under produced because its market value is not reflective of the real value of that commodity. Usually, market failure can result when the company under consideration either produces the good in excess or under produces it. These are the major justifications for government entry. There are many examples of positive externalities in society today. For instance, carrying out immunisation programs is usually assumed to cause some spill over effects. Offering milk to school children for free has a number of unaccounted social benefits. Training and developmental programs may also lead to sudden changes in people’s lifestyles. Adoption and growth of renewable energy is another fine example and so is introduction of new methods of production especially within industries. (Zupan & Browning, 1999) Shown below is a graphical illustration of what could occur to a certain society when there is a positive externality and some government intervention is carried out. Price (P) Supply (private) Supply (after) Demand (private) Q1 Q2 Quantity of goods (Landsburg, 2008) From the above illustration Q1 represents the free market amount of goods that are supplied while Q2 refers to the optimal amount of goods supplied after government intervention. The line sloping downward represents price demanded in the free market (with the positive externality). The lines sloping upward represent price supplied with the upper one being the free market supply while the lower one is the supply price after incorporation of the positive externality. Here, the price externality added to the amount supplied in the free market will result in a supply (price that increases the special benefits i.e. Supply (social benefits) = Supply (free market) - external benefits (to other businesses). The triangle in the middle represents all the positive results that will come out of adopting an optimal quantity and an optimal price. The equilibrium benefit that exists within the free market if all the social and economic benefits of the commodity had been incorporated is represented by the lower line. The Quantity supplied corresponds to Q1. Such a quantity cannot be sufficient to meet prevailing social welfare. If the government makes an intervention such that the quantity produced is increased, then there will be a shift to Q2 that will then lead to a higher benefit. This is because there is more consumption from more consumers and more benefits to the supplier who will be having a greater output level. It has been assumed that all government interventions are made so as to heighten consumption of the commodity. (Humphrey, 1992) Ways to correct for a positive externality (discussion of the options) Governments may choose to adopt a variety of techniques when dealing with the issues of positive externalities. For instance, they have the alternative of increasing funding for growth of a certain public service or program. This can go a long way in encouraging people to consume more of that public service /good. In other circumstances, the government may opt to provide that good or service directly. This means that more producers will be available thus leading to greater social benefits. A tax incentive is also another viable option because producers will be encouraged to generate more. Alternatively, legislations could be passed requiring establishment of that service or good within certain geographical boundaries in the country. Lastly, the government may opt to enact a price floor in which suppliers are supposed to sell the commodity at a preset price. However, the latter strategy is not always effective as it may lead to alterations in supplier and consumer surpluses. (Mead, 2007) A case study where a positive externality occurs in a market within my home country One example where the government intervened was in vocational training. This came as a result of a gap that excited within the UK job market especially when compared to other member states of the European Union. Additionally, data indicates that these gaps in skills have been caused by a market that emanated out of a positive externality. Prior to government intervention and even today, a number of employers who invest in training their employees usually loose them to others who are ‘free riders’. Consequently, firms that invest in an employee may reap only a portion of their investments from that employee because other competitors usually take them up. It also became necessary for the government to intervene in such a scenario because there was another positive externality that could have led to market failure. First of all, those employees in need of vocational training may not be able to come up with all the payment for their training. Consequently, they tend to borrow funds from lending institutions solely on the belief that their training will provide them with positive returns. In most scenarios, this is made possible but the overall benefits go to the lending institutions. Employers or vocational training stakeholders may not be aware of the effect that their actions brought to other individuals. (Sheffrin & O’Sullivan, 2001) Ways in which my government has addressed the presence of a positive externality The government has tried a number of options so far. First, it passed a piece of legislation that was deigned to encourage vocational training. This was through the 2002 Levy for Industrial Training. Additionally, the government has heightened its level of investment in vocational training by funding and even operating vocational schools. The major goal behind this move is to fill up some of the gaps in vocational skills within the UK. The government was also driven by a need to boost human capital, improve productivity and thus build the economy. Suggestions on better ways of dealing with the case study The latter methods have not yet achieved the full results that the government had anticipated. Consequently, there may be a need to look into more direct ways i.e. working with employers. Since employers are usually the ones that initiate these forms of training and they are also the same ones that need to be encouraged. For instance, those businesses that offer vocational training for their staff can be offered tax credits. This means that employers will no longer worry about the possibility of short term gains and employees themselves will also be encouraged to study. PART C –tax on luxury cars Discussion of the incidence of tax on luxury cars Luxury vehicles are those types of automobiles that possess a high elasticity of demand when incomes rise. In other words, the more the incomes of consumers increase, the more those consumers will purchase the luxury item. (Yorku, 2001) Currently, the government imposes a series of taxes on vehicles in general and luxury cars specifically. Consequently, the total sum of taxes on this category is an addition of the two types of taxes. A number of luxury vehicles are not manufactured within the United Kingdom, this means that import tax must be paid. Additionally, the government has passed the luxury vehicle tax that is aimed at boosting new cars rather than second hand ones. This assumption does make sense because the region has a big population base. The prices of luxury vehicles have been affected by this tax because of dwindling supply. Price elasticities of demand and supply of luxury cars It should be noted that the way luxury vehicles are treated and perceived may depend upon the individual under consideration. However, some economists argue that hiking prices of luxury vehicles can lead to the perception that the good has a higher value/ quality and that it is therefore worth buying. Besides that, some people may assume that a luxury automobile represents the high end of the market and should therefore be placed at a high price. Consequently, placing taxes on such items would make some consumers think that its price is associated with its quality thus making them buy it. (Smith & Williams, 1981) The government often decides to raise luxury taxes for those commodities that posses an inelastic demand. This is because it can be able to collect a high amount of revenue from the groups under consideration. If the demand for that commodity remains inelastic, then people will still continue purchasing the same quantity irrespective of price increases. However, luxury vehicles are not price inelastic; in fact, most people have the capacity to purchase these luxury vehicles from other parts of the world. Consequently, this has led to minimal purchase increases. All in all, it can be said that the price elasticity of demand is rather low while the price elasticity of supply is high for taxed luxury vehicles. Examples of such tax The government asserted that luxury vehicles would be those vehicles that exceeded a certain price range. One would assume that the Rolls Royce and other similar models would be targeted by such an initiative. However, this was not the case, as matter of fact, it was found that most four wheel drives were covered and they included the Ford, Nissan Patrol and Mitsubishi Pajero. Besides that, the most popular vehicles that were taxed under this new tax program were Land cruisers made from Toyota. In the end, only a relatively small number of vehicles were sold as luxury items because the new category of individuals began opting for second hand alternatives rather than new ones. Another issue that had been forgotten was the amount of fuel consumed by such vehicles. It was found that these vehicles were more fuel efficient than others. Consequently, the overall positive repercussions that emanated from such a move are doubtful. Conclusion It has been found that price ceilings tend to create only superficial positives as seen in the case study; it is better for governments to opt for more effective measures that could curb market failure. Also, another case study has shown that government intervention in positive externalities may not always lead to immediate results. These may take longer than anticipated. Lastly, taxes on luxury vehicles are very intricate as their effects largely depend on interpretations made by vehicle buyers. References Smith, J. & Williams. A. 1981. ‘Non binding price controls in competitive markets.’ The American Economic Review. 71(2): 992 Sheffrin, S. & O’Sullivan. T. 2001. Economic Tools and Principles. NJ: Prentice hall Zupan, M. & Browning, E. 1999. Microeconomics; theory and applications. MA : Addison Wessley. Yorku. 2001. The Global market for luxury goods. Retrieved 9 Apr. 2009 http//www.library.yorku.ca/ Mead, A. 2007. ‘Interest rates are prices.’ Cato Institute Report. 3: 45 Humphrey. T. 1992. ‘Origins of Demand and Supply Geometry.’ Economic Review 23 (5): 98 Smith, A. 2002. 15 fallacies of fundamentals of economics. Retrieved 9 Apr. 2009 from http://www.columbia.edu/dlc/wdu/ Gills, M. 2008. ‘Basic Demand and Supply.’ Wolfram Demonstrations Project. 34: 59 Landsburg. S. 2008. Price theory and applications. New York: Wiley and Sons Henderson, H. 2006. Supply and Demand. London; Mc Millan Read More