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An indirect tax is a tax on the expenditure on goods.
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
As seen in the section on supply, 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 below:
The incidence of taxation
The incidence of taxation is the burden of tax shared
between buyers and sellers.
The following diagram shows how this is worked out:
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.
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
·
When demand is inelastic the consumer’s tax burden is greater
than the producer’s.
·
When demand is elastic the producer’s tax burden is greater
than the consumer’s.
·
When supply is elastic the consumer’s tax burden is greater
than the producer’s.
·
When 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.
Indirect Taxes – Task
Supply
tends to be more elastic in the long run than the short run.
Assume that a tax is placed on a previously untaxed good.
How will the incidence of this tax change as time passes?
Use a diagram/s to demonstrate your answer.
Notes on the
internet
VAT
- who pays what?
VAT
- a demanding tax
VAT
- taxing externalities
You may wish to look at the following notes if you want more help!
Indirect
taxes - what happens to market prices?
Progressive
or regressive - who pays what?
Elastic
or inelastic demand - who pays how much?
Taxing
externalities
Inland Revenue
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HM Treasury Home Page
Customs and Excise Home Page
Institute for Fiscal Studies
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