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 sold.

Effect 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:

The incidence of taxation

The incidence of taxation is the burden of tax shared between buyers and sellers.

The diagram 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 P_2-tP₂ac.  That part of the government revenue not paid by the consumer must therefore have been paid by the producer and producer contribution is P_2-tP₁bc.

The total government’s tax revenue is equal to the specific tax per unit multiplied by the equilibrium output after tax.

The consumer’s 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 government’s revenue.

The producer’s tax burden is equal to the area of the government’s tax revenue which is not paid by the consumer.  This is the bottom portion of the government’s tax revenue.

Tax incidence and elasticity

·        Demand is inelastic the consumer’s tax burden is greater than the producer’s.

·        Demand is elastic the producer’s tax burden is greater than the consumer’s.

·        Supply is elastic the consumer’s tax burden is greater than the producer’s.

·        Supply is inelastic the producer’s tax burden is greater than the consumer’s.

The relationship between elasticity and tax incidence is exactly when an ad valorem tax is levied on goods.

Further observations

Government’s tend to impose specific taxes on alcohol, petrol and cigarettes the reasons for this are:

Demand will be relatively unaffected and so firm’s will lose little in the way of revenue.  Government’s 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.