What are indirect taxes?

An indirect tax is imposed on producers (suppliers) by the government. Examples include excise duties on cigarettes, alcohol and fuel and also value added tax. Taxes are levied by the government for a number of reasons – among them as part of a strategy to curb pollution and improve the environment.

A tax increases the costs of a business 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 meaning that demand is responsive to a change in price. The producer must absorb most of the tax itself (i.e. accept a lower profit margin on each unit sold). When demand is elastic, the effect of a tax is to raise the price – but we see a bigger fall in equilibrium quantity. Output has fallen from Q to Q1 due to a contraction in demand.

In the right hand diagram above demand for the product is inelastic and therefore the producer is able to pass on most of the tax to the consumer through a higher price without losing too much in the way of sales.

Who pays the tax? The burden of taxation

Taxation, elasticity of demand and government revenue

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.

The table below shows the demand and supply schedules for a good

Price (£)	Quantity Demanded	Quantity Supplied (Pre-tax)	Quantity supplied (Post-tax)
10	20	1280	600
9	60	1000	400
8	150	850	150
7	260	600	50
6	400	400
5	600	150
4	900	50

1	What is the initial equilibrium price and quantity?	Price = £6 Quantity = 400
2	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
3	Find the new equilibrium price after the tax has been imposed	New price =£8
4	Calculate the total tax revenue going to the government	Tax revenue = £450
5	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

 

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 the air passenger duty which imposes a standard tax of £10 for flights within the European Economic Area (EEA) and £40 for flights outside of the EEA

Ad valorem taxes

Where the tax is a percentage of the cost of supply – the best example of this is value added tax currently levied at the standard rate of 17.5% or Insurance Premium Tax which is taxed at 5%.
In the diagram below, an ad valorem tax has been imposed on producers. The market equilibrium price rises from P1 to P2 whilst quantity traded 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 taxation is a good example of a product on which both specific and ad valorem taxes are applied. The data below is taken from information produced by the UK Customs and Excise and breaks down the taxation of cigarettes for a typical brand in the mid-price category. Over the last ten years, the specific duty on cigarettes has nearly doubled from 105 pence in 1994 to 200 pence after the March 2004 Budget. When we add value added tax to the equation, the total tax on a standard packet of twenty cigarettes has grown from 186 pence in 1994 to 365 pence in 2004. Cigarette taxation in the UK is the highest among European Union nations. Total taxation as a percentage of the price has remained fairly stable over the last decade at 80 – 81 per cent.

Taxation on Cigarettes Typical Brand In Mid Price Category
(for a pack of 20 cigarettes)
	Typical	Pre-tax	Specific	Ad	VAT	Total	Tax as %	Specific
	Price	Price	Duty	Valorem		Tax	of Price	Duty as % of
				Duty				Total Tax
1994	232	46.4	104.7	46.4	34.6	185.6	80.0	56.4
2000	367	66.4	165.2	80.7	54.7	300.6	81.9	55.0
2004	449	83.7	199.6	98.8	66.9	365.3	81.3	54.6

 

In recent years the government has encouraged a switch away from direct taxation on income towards indirect taxes on the goods and services that we buy and then consume. A wider range of indirect taxes has been introduced including the Insurance Premium Tax, the Air Passenger Duty and the Landfill Tax.