What would be the likely effects of a 20% tax on sugary drinks in the UK?

A 20% tax on the sale of soft drinks with a high sugar content in the UK would be an example of an ‘ad valorem’ tax. This means that it the size of the tax is based on the value of the transaction or good. In this case, a tax would be levied as a percentage of the value of the sale, as opposed to a fix cost per unit. Therefore, a higher tax would be levied on sales of greater value. It is also an indirect tax. An indirect tax is one that is imposed on spending (in this case as a duty on the sale of sugary drinks), rather than income, wealth, or profit (direct tax). This tax would aim to correct market failures caused by sugar being a demerit good and information failure, in that people are likely not well informed about the negative health effects of sugar. Therefore, since sugary drinks have less merit than people perceive, there is a much greater demand for it than there should be. This tax would have several microeconomic and macroeconomic effects which I will discuss.

Firstly, it would greatly increase cost for producers, and they will now be able to supply less at each price. This means that there would be a left shift of the supply curve. Furthermore, supply will also become more price inelastic (as the cost of the tax is greater at higher prices, so gradient of the supply curve will be steeper). We observe these changes on the diagram below.

The diagram shows that quantity demanded at the new price is lower than before, so output would decline from Q1 to Q2, as people would be less inclined to buy at higher prices. This would mean a drop in consumption and therefore less health issues in society, improving social welfare. Although there is technically a deadweight loss (‘welfare’ loss indicated by the red triangle), because of a loss in the sum of producer and consumer surplus, it is offset by the fact that sugar has negative externalities of increasing healthcare cost. Therefore, a decrease in output and consumption is likely to reduce health problems and reduce healthcare cost on the NHS. According to one study, a sugar tax would save the NHS up to £300m over 20 years and by reducing incidence of obesity, diabetes, heart disease and cancer.

However, it must be noted that sugary drinks are likely to be fairly demand inelastic. This is because of habitual behaviour and addictiveness. On the other hand, sugary drinks are mostly consumed by lower income households which are likely to respond more to price change. This elasticity will be key in determining to what extent there will be a reduction in consumption and therefore a reduction in NHS cost. If sugary drinks are indeed inelastic because of their addictiveness, there would likely be a very small effect on healthcare spending.

Also, if only sugary drinks are taxed, people who like sugar would simply turn to other products. The people who end up needing some form of healthcare relating to bad eating habits are likely addicted to sugar and would either continue to consume sugary drinks or start buying other sugar products to get their fix if the price goes too high for them. Either way, these people will likely continue to put further stress on the NHS. A better solution may be to tax all sugar products.

Secondly, the tax is likely to increase inequality. This is because of the regressive nature of the tax. Sugary drinks are much more likely to be consumed by lower income households because they are more likely to be less educated so there is a greater incidence of information failure. Also, sugary drinks have a high calorie to price ratio – they are both cheap and offer a high calorie content favouring poorer households. Therefore, they are much more likely to bear the brunt of the tax than richer households, who consume sugary drinks far less. Also, the inelasticity of the demand curve means that a much greater share of the tax is paid by the consumers (denoted by the blue rectangle on the diagram) compared to producers who pay a much smaller share (denoted by the green rectangle on the diagram). Furthermore, even if this wasn’t a factor, an increase in spending (as a result of the tax) as a percentage of their income for rich people would be tiny but it would mean a much larger increase in spending for a low-income household. Therefore, wealth inequality would widen.

However, it could be argued that if higher prices from the sugar tax actually deter people from buying sugary drinks, then it doesn’t cause inequality and reduces consumption, which is the desired effect. Therefore, the success of the tax depends greatly on demand price elasticity – how much would the 20% increase in price from the tax cause sugary drinks consumption to go down by. It should also be noted that healthier foods as substitutes are much more expensive, so it is likely that sugar products are still much cheaper for low-income households so they might not change their eating habits. That is why cross price elasticity is also important – to what extent would an increase in price of a good (sugary drinks) cause an increase in the demand for substitutes (eg healthy juices).

Thirdly, the tax would also help reduce government budget deficit. Because of the inelasticity of demand and an inelastic supply (as an effect of the ad valorem tax), there will be little reduction in output and quantity demanded and yet a significant increase in price. Therefore, the tax revenue from an ad valorem tax on sugary drinks would be very high. Tax revenue is denoted by the sum of the blue and green rectangles on the diagram. It is estimated that the tax will raise over £22 million in revenue per month. Furthermore, if the tax is successful, consumption of sugary drinks would decline, less people would face health problems and the NHS would save a significant amount of money. Through the tax, both tax revenue would decrease and the UK government would save up to £15 million a year on healthcare spending, which would help reduce the UK’s budget deficit. Alternatively, the same money could be spent by the government to boost other sectors of the economy. This might increase AD and increase output in the economy.

Another macroeconomic effect would be that trade deficit would decrease. As a net importer of sugar, the UK imports 600,000 tonnes of sugar annually. If quantity demanded in the UK goes down as a result of the tax on sugary drinks, it would cause a decline in imports. This would mean that the trade deficit (value of exports – imports (X-M)) would go up. Therefore, AD would increase, shifting outward, leading to an increase in output. This would cause an increase in economic growth.

However, the effect of the tax on trade deficit is likely to be minimal because sugary drinks are likely demand inelastic. Also, even if they are demand elastic, it would simply make consumers shift to other sugar products and therefore imports may not even decline.

In summary, an indirect ad valorem tax on sugary drinks would likely have cause a reduction in healthcare spending and a large increase in government tax revenue. It may also increase wealth inequality slightly, since it would be regressive. The extent of all of these effects would largely be dependent on the elasticities in the sugar market, so investigating through economic research the precise elasticities of the market would be key in evaluating the effects of the sugar tax. Time will tell how successful the tax will be in the UK.