Consumption Tax Effects in a Small Importing Country

In many instances domestic policies affect an industry that is initially either an exporter or an import-competitor. In this example we consider the price, production and welfare effects of a consumption tax when the taxed commodity is initially imported in the country.

We depict the initial equilibrium in the adjoining diagram. The free trade price is given by P_FT. The domestic supply is S₁ and domestic demand is D₁ which determines imports in free trade as D₁ - S₁ (the red line).

When a specific consumption tax "t" is imposed the consumer price will rise by the amount of the tax to P_C. The higher price paid by consumers will reduce their demand to D₂. The producer price will remain at the free trade price indicated at P_P = P_FT and hence domestic supply will remain at S₁. The tax will reduce imports from (D₁ - S₁) to (D₂ - S₁).

The welfare effects of the consumption tax are shown in the Table below. The letters refer to the area in the previous graph. Red letters indicate losses while black letters indicate gains.

Consumers suffer a loss in surplus because the price they pay rises by the amount of the consumption tax. Producers experience no change in surplus since the producer price (i.e., the price received by producers) remains at the free trade level. Note that even though imports fall, this decrease has no positive effect on producers in this situation. Finally, the government receives tax revenue from the consumption tax. The revenue is calculated as the tax, t, (given by P_C - P_P) times the quantity purchased, D₂.

Since the cost to consumers exceeds the benefits accruing to the government, the net national welfare effect of the consumption tax is negative. Although some segments of the population benefit, there remains a consumption efficiency loss, given by area c.

In the rest of the world, the small country assumption implies that this domestic policy (the consumption tax) would have no noticeable effects. Foreign prices would remain unchanged and although domestic imports would fall, these changes in trade volumes would have no noticeable impact in the rest of the world. Thus the welfare effects are considered to be zero in the rest of the world.

International Trade Theory and Policy - Chapter 95-2B: Last Updated on 10/17/02