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Thursday, August 25, 2005

American Fiscal Policy

Someone asked me why the United States Government, under the leadership of President George W. Bush, seems to advocate Fiscal policy, i.e. reducing taxes, as a means to solve all problems while using legislation rather than Fiscal policy to dissuade consumption of products which are perceived as harmful such as cigarettes, alchol and gasoline/petrol.

Taxes on products which are perceived to be harmful are referred to as "sin taxes". The demand for these products is inelastic, which means that the demand curve is steep. In other words, if you were to draw a graph with price on the vertical axis, quantity on the horizontal axis and the origin in the bottom left hand corner, then a demand curve would be drawn as a line that demonstatres that as the price rises the quantity demanded reduces. An Inelastic demand curve would show that as the price rises the quantity demanaded reduces little, i.e. a steep line. A perfectly inelastic demand curve would be a vertical line since as the price rises the quantity demanded remains constant.

The fact that "sin taxes" are levied on goods with an inelastic demand curve means that significant taxes may be levied, and so significant tax revenue may be gained, without reducing the quantity of the good which is consumed significantly. If a government intends to reduce consumption of certain products, tobacco, alchol, gasoline/petrol etc. then they may do so by increasing taxes on those products.

The advantage of using fiscal policy to reduce consumption of bad products is that the government is able to both reduce consumption and gain revenue for use on other government projects which are perceived as being more beneficial to the public good. The disadvantage of using fiscal policy to reduce consumption is if reduced consumption causes a loss to the economy as a whole. This concept of tax benefit is known as Marginal Excess Burdon of a tax. Unfortunately, many sin taxes are associated with hidden costs, i.e. the cost of pollution on the environment or the cost of sickness on a person's happiness. In countries where healthcare is provided by the government sin taxes tend to attept to dissuade consumers from behaviour which could increase the quantity of government provided healthcare consumed. An example of this is the high taxes imposed upon cigarettes in the UK as a means to reduce the incidence of lung cancer and subsequently reduce the cost to the government for lung cancer treatment and maintain a person at a state of wellness and maximal productivity.

The problem with using legislation to reduce consumption of bad products is that there is a net monetary loss for the government in terms of the real monetary costs associated with policing the legislation versus the often imaginary, or intangible, benefits which the reduced consumption brings. For example, the government of George W. Bush is currently legislating that by 2008 cars must be more efficient in terms of fuel economy than they are today. Ignoring the details of the policy the goals are basically to reduce pollution and dependence upon oil while maintaining a low price for gasoline/petrol. This policy will impose a real monetary cost to the US government which must be paid either by levying additional taxes or by borrowing money through the issuing of government bonds. The benefit of this policy has no real monetary benefit, not to say that the goals are not noble, however, the goals cannot be easilly quantified into hard currency. The costs of the policy are clear but the benefits are not.

Clearly there is a disconnection between the use of fiscal policy in the United States for increasing consumption for some goods, through tax cuts, while using costly government legislation and monetary policy to reduce consumption for other goods. Amazon has a great book about Economics by John Sloman available here.

Do you believe that legislation is more effective, in terms of cost and benefits, in dissuading consumption of economic bads, i.e. goods that decrease economic utility, than fiscal policy is?

Have fun pondering the details of government policy, if you have any comments please let me know and if you have any other questions which you'd like me to answer for free please send them to Ben Dash at


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