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A domestic consumption taxA tax collected by a government on sales of a particular product. is a tax collected by a government on sales of a particular product. The tax can be levied either as an ad valorem tax (a percentage of the value of the good) or as a specific tax (a 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 the goods sold in the domestic market regardless of where the goods are produced. An import tariff or export tax, on the other hand, is levied only on units of the goods actually imported or exported. An import tariff and an export tax are classified as trade policies, whereas the consumption tax is a domestic policy.
Domestic consumption taxes are often used as a source of government revenue. In the United States, the most common type of ad valorem consumption tax is the sales tax 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. Thus sometimes consumption taxes are used to discourage certain types of consumption.
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 separate scenarios. 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 initially importing the good from the rest of the world.
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”