Assess the effects of an increase in VAT of 5% on
externalities and consumers. (__/15 marks)
Externalities are the costs or benefits of economic activity that affect a third party not
involved in the transaction. Negative externalities are those that do harm or are not desired
by society. Positive externalities are those that serve society well.
One impact of the government’s decision to increase VAT by 5% will be a decrease in overall
demand for products. This is because for firms, a tax will result in an increase in the cost of
production, resulting in a negative shift in quantity supplied from S to S1+T, and thus an
increase in price from P to P1.
Price S1 + T S
P1
P
Q1 Q Quantity
This is because VAT is a form of advalorem tax which is a value-based tax which is usually
expressed as a percentage. Being a form of indirect tax, the burden can be transferred from
producers to consumers through higher prices, resulting in a net welfare loss equal to the
area of shaded region above. As a result, there would be a contraction in demand from Q to
Q1.
On the other hand, the extent of the contraction in demand as a result of an increase in
price for consumers is dependent of the price elasticity of demand of the given product or
service. For addictive products, the quantity demanded is price inelastic. This means that
the quantity demanded will be affected at a less the proportional amount compared to price
changes. For example, cigarettes have a relatively low-price elasticity as they are addictive
which means consumers may find it harder to alter their habits. Therefore, the effect of an
increase in VAT of 5% will not have a universally substantial effect on consumer demand for
all products.
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