Author: Geoff Riley Last updated: Sunday 23 September, 2012
An indirect tax is imposed on producers (suppliers) by the government. Examples include duties on cigarettes, alcohol and fuel and also VAT
VAT is a tax placed on the expenditure / a tax set as a percentage of the price of a good)
A tax increases the costs of production causing an inward shift in the supply curve
The vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit
With an indirect tax, the supplier may be able to pass on some or all of this tax onto the consumer through a higher price
This is known as shifting the burden of the tax and the ability of businesses to do this depends on the price elasticity of demand and supply
In the left hand diagram, demand is elastic so the producer must absorb most of the tax and accept a lower profit margin on each unit. When demand is elastic, the effect of a tax is to raise the price – but we see a bigger fall in quantity. Output has fallen from Q to Q1.
In the right hand diagram demand for the product is inelastic and therefore the producer is able to pass on most of the tax to the consumer by raising price without losing much in the way of sales.
The table below shows the demand and supply schedules for a good:
What is the initial equilibrium price and quantity?
Price = £6
Quantity = 400
The government imposes a tax of £3 per unit. The new supply schedule is shown in the right hand column of the table – less is now supplied at each and every market price
Find the new equilibrium price after the tax has been imposed
New price =£8
Calculate the total tax revenue going to the government
Tax revenue = £450
How have consumers been affected by this tax?
There has been a fall in quantity traded and a rise in the price paid by consumers – this leads to a fall in economic welfare as measured by consumer surplus
Who pays the tax? The burden of taxation
The Government would rather place indirect taxes on commodities where demand is inelastic because the tax causes only a small fall in the quantity consumed and as a result the total revenue from taxes will be greater. An example of this is the high level of duty on cigarettes and petrol.
Specific taxes: A specific tax is where the tax per unit is a fixed amount – for example the duty on a pint of beer or the tax per packet of twenty cigarettes. Another example is air passenger duty
Ad valorem taxes: Where the tax is a percentage of the cost of supply – e.g. value added tax currently levied at the standard rate of 15%. In the diagram below, an ad valorem tax has been imposed on producers. The equilibrium price rises from P1 to P2 whilst quantity falls from Q1 to Q2.
Note that the effect of an ad valorem tax is to cause a pivotal shift in the supply curve
This is because the tax is a percentage of the unit cost of supplying the product. So a good that could be supplied for a cost of £50 will now cost £58.75 when VAT of 17.5% is applied whereas a different good that costs £400 to supply will now cost £470 when the same rate of VAT is applied
The absolute amount of the tax will go up as the market price increases
Tobacco is an example of a product on which both specific and ad valorem taxes are applied.