Differentiated taxation of products with harmful externalities

Behavioral economics is a combination of psychology and economics that researches markets where agents display human limitations and complications such as specific perceptions and preferences. Within the context of taxation, behavioral economics encompasses “corrective” taxes which usually aim to achieve targeted changes in consumers’ and producers’ behaviors.

The rationale behind this approach is that economic choices of consumers and enterprises often lead to a market failure in the form of an under or over-production of certain goods (from the point of view of maximizing the societal welfare). Tax policies based on behavioral economics, therefore, are not solely aimed at increasing the final prices of the taxed products, respectively, raising higher public revenues. Taxation is also used as a tool with broader impact on societal welfare as well as a source of revenue to fund publicly provided goods and services related to the harmful goods / activities. Examples include public health services for tackling diseases from alcohol or tobacco abuse, financing of social security programs etc.

Differentiated taxation is based on the logic of behavioral economics. This type of taxation provides for a different tax burden and treatment of products usually deemed to entail specific negative externality as their major characteristic. The said externality may relate to a risk for the health of consumers, detrimental environmental effect, or both.

The ultimate goal of differentiated taxation is to influence human behavior in a specific manner by altering the decision-making stimuli for either or both producers and consumers. The said stimuli may be “negative,” such as taxation leading to increased price levels discouraging manufacturing or usage of a specific product, but also “positive,” by allowing producers and consumers to easily switch to less hazardous alternatives by making substitutes more affordable and attractive or replace most harmful contents with less hazardous.

The said goals are usually targeted by means of taxes which are:

• levied on final consumption (retail sales);
• assessed as one-off taxes (rather than being cumulative);
• applied to a limited number of products, which are explicitly differentiated, i.e., are not general taxes on all goods;
• aimed to make the production / consumption of the specific product less desirable from consumers’ or producers’ perspectives (or both);
• reflect the level of harm or volume of harmful content in the final product.

The team of Ernst & Young Bulgaria EOOD has prepared an analysis report entitled "Differentiated taxation aimed at reducing risks from products with harmful externalities" assessing recent domestic and EU trends related to differentiated taxation for several types of products with harmful external effects:

• Energy products
• Food and non-alcoholic beverages
• Alcohol beverages
• Tobacco and nicotine products