International Trade Theory and Policy
by Steven M. Suranovic

Trade 95-2

Domestic Consumption Taxes

A domestic consumption tax is a tax collected by a government on sales of a particular product. The tax can be levied either as an ad valorem tax (% of the value of good) or as a specific tax (charge per unit of the good sold). The domestic consumption tax is different from an import tariff or an export tax. The consumption tax is levied on all of the goods sold in the domestic market regardless of where the goods are produced. The consumption tax can be levied on products that are imported or on products that are produced domestically; it doesn't matter. An import tariff or export tax, on the other hand, are levied only on units of the goods actually imported or exported.

Domestic consumption taxes are generally used as a source of government revenue. In the US the most common type of ad valorem consumption taxes are sales taxes levied by state governments. The most common specific consumption taxes include gasoline, alcohol and cigarette taxes. The latter two are sometimes referred to as "sin" taxes, since they are also designed to reduce consumption of potentially harmful substances.

We will analyze the international trade effects of a domestic consumption tax using a partial equilibrium analysis. We will assume that the market in question is perfectly competitive and that the country is "small". We will also ignore any benefits the policy may generate such as creating a more pleasing distribution of income or generating valuable external effects. Instead we will focus entirely on the producer, consumer and government revenue effects of each policy.

Next we consider the effects of a consumption tax under two different initial conditions. In the first case the tax is implemented in a country that is not trading with the rest of the world. This case is used to show how a domestic policy can cause international trade. The second case considers the price and welfare effects of a consumption tax implemented by a country that is intitially importing the good from the rest of the world.

Consumption Taxes as a Source of Trade

Consumption Tax Effects in a Small Importing Country

International Trade Theory and Policy - Chapter 95-2: Last Updated on 12/24/06