An indirect tax is
a tax on the expenditure on goods, often this is done to discourage the
consumption of a good that leads to a negative externality.
These are taxes paid by the seller of the good, who usually asks the
consumer to pay some or all of it.
Specific taxes are
indirect taxes where a fixed sum is paid per unit sold.
Examples of such taxes in the UK are excise duties on tobacco,
alcoholic drinks and petrol.
Ad valorem taxes
are indirect taxes where a certain percentage is added on to the price of
each unit sold. A UK example is
Value Added Tax (VAT) currently standing at 17.5%.
A subsidy is a
grant given by the government which is usually a fixed sum granted per unit
on supply curves of the different indirect taxes
Taxes have the
effect of raising costs of production a thereby shifting the supply curve to
the left. For a specific tax
this will mean that the shift will be a parallel one because the amount of
tax is the same at all prices, the vertical distance between the supply
curves will give the amount of specific tax.
For an ad valorem tax the curve will swing to the left, because the
amount of tax per unit increases as prices get higher, thereby widening the
gap between the pre tax supply curve and the post tax supply curve. This situation is shown on the diagrams overleaf:
incidence of taxation
The incidence of
taxation is the burden of tax shared between buyers and sellers.
overleaf demonstrates how this is calculated:
The specific tax
per unit is shown as the vertical distance (t) between the two supply curves.
The price to the consumer has risen to P2 and output of the
good has fallen to Q2. The
incidence or burden for the consumer can be calculated as the change in price
multiplied by the quantity of the good consumed, this gives the area P1P2ab.
The total government revenue from the tax can be found by multiplying
the specific tax per unit (t) by the quantity bought/sold Q2 this
gives the area P2-tP2ac.
That part of the government revenue not paid by the consumer must
therefore have been paid by the producer and producer contribution is P2-tP1bc.
governmentís tax revenue is equal to the specific tax per unit multiplied
by the equilibrium output after tax.
tax burden or incidence is equal to the change in price multiplied by the
equilibrium output after tax. It
is the top portion of the governmentís revenue.
tax burden is equal to the area of the governmentís tax revenue which is
not paid by the consumer. This
is the bottom portion of the governmentís tax revenue.
incidence and elasticity
Demand is inelastic the consumerís tax burden is greater than the
Demand is elastic the producerís tax burden is greater than the
Supply is elastic the consumerís tax burden is greater than the
Supply is inelastic the producerís tax burden is greater than the
between elasticity and tax incidence is exactly when an ad valorem tax is
levied on goods.
to impose specific taxes on alcohol, petrol and cigarettes the reasons for
Demand will be
relatively unaffected and so firmís will lose little in the way of revenue.
Governmentís revenue is highest when taxing goods with inelastic
demand. Recent governments have tried to persuade consumers to use
less of these goods for health/environmental reasons.