Taxing Sugar-Sweetened Drinks
The government of a Caribbean country is considering a specific tax of EC$1.00 per 500 ml bottle on sugar-sweetened beverages (SSBs). The current retail price is EC$5.00 and annual sales are 2 million bottles. Economists estimate the price elasticity of demand for SSBs is 0.6 (absolute value) and the price elasticity of supply is 1.5. The health ministry wants consumption to fall by at least 15% to reduce obesity and diabetes costs. The finance ministry wants to raise at least EC$1.5 million a year. Beverage producers warn that bottling jobs will be lost and that consumers will switch to imported powdered drinks that are not taxed. The tax will be collected from producers. A backbencher argues that the tax will simply be passed entirely to consumers, so it will not change behaviour. You are asked to prepare a briefing.
1. Using the elasticities, estimate the effect of the tax on the price consumers pay, the price producers receive, quantity sold and tax revenue. Show your working.
Read the worked answer
The tax burden is shared according to relative elasticities. The consumer share of a specific tax is:
Consumer share = elasticity of supply / (elasticity of supply + elasticity of demand) = 1.5 / (1.5 + 0.6) = 1.5 / 2.1 ≈ 0.714.
So consumers bear about 71.4% of the EC$1.00 tax, and producers bear about 28.6%.
- Consumer price rises by about EC$0.71, from EC$5.00 to EC$5.71, a 14.3% increase.
- Producer price received falls from EC$5.00 to about EC$4.71, a 5.7% reduction.
- Quantity demanded falls by roughly 0.6 × 14.3% ≈ 8.6%, from 2 million to about 1.83 million bottles.
- Tax revenue = EC$1.00 × 1.83 million ≈ EC$1.83 million a year.
These are estimates. In the short run demand may be less elastic; in the long run it may be more elastic as consumers find substitutes. The revenue estimate assumes the tax is collected on all sales and there is no evasion.
2. Assess whether the tax meets the health and revenue objectives. Explain the role of elasticity and substitution.
Read the worked answer
Revenue objective: the tax raises about EC$1.83 million, which exceeds the EC$1.5 million target. So the finance ministry's goal is met.
Health objective: consumption falls by only about 8.6%, not the 15% the health ministry wants. The tax is therefore too small, or demand is too inelastic, to hit the health target on its own. Because PED is 0.6, consumers are not very responsive: many continue buying despite the higher price. The producer price also falls, so some of the tax is absorbed by firms rather than felt by consumers.
Substitution matters. Consumers may switch to untaxed powdered drinks, fresh juice or informal imports. If those substitutes are high in sugar, the health gain is smaller than the fall in taxed SSB sales suggests. The tax base may also erode. A larger tax, or a tax that covers a wider range of sugary products, would reduce substitution and cut consumption more. The judgement is that the tax is a good revenue instrument but a weak health instrument at EC$1.00 per bottle.
3. The backbencher says the tax is fully passed on to consumers. Evaluate this claim and discuss who bears the burden.
Read the worked answer
The claim is incorrect as a general statement. Full pass-through would require either perfectly inelastic demand or perfectly elastic supply. Here demand has PED 0.6 and supply has PES 1.5, so the burden is shared. Consumers pay about 71% of the tax and producers about 29%.
Producers bear a burden because their received price falls. If bottling is competitive, this squeezes profit margins and may lead to job losses, as producers warn. If producers have market power, they may pass on more than the elasticity formula suggests. Consumers bear a burden through a higher price, but because demand is inelastic, they do not cut purchases proportionally.
The backbencher is right that the price will rise, but wrong that behaviour will not change: quantity falls by about 8.6%. The policy's effect on behaviour depends on the size of the tax and on available substitutes. A briefing should present the incidence estimate and note that the health gain is limited unless the tax is larger or combined with labelling, advertising controls and subsidies for healthier alternatives.