Indirect Taxes (Specific & Ad Valorem) (Cambridge (CIE) A Level Economics): Revision Note

Indirect taxation

• An indirect tax can be either specific or ad valorem

• Both shift the supply curve to the left, raising the price paid by consumers and reducing the quantity traded

• The key difference is in how the tax is calculated:

  • A specific tax is a fixed amount per unit, e.g. £0.50 per unit - the supply curve shifts left by the same vertical distance at all output levels, so the two supply curves are parallel

  • An ad valorem tax is a percentage of the price, e.g. 20% VAT - the tax per unit rises as price rises, so the shifted supply curve diverges from the original

Specific tax on a negative externality of production

• Governments impose specific taxes on goods whose production generates negative externalities — where MSC > MPC at the free-market equilibrium

• The aim is to internalise the externality by making producers face the full social cost of production

• This moves output closer to the socially optimal level where MSB = MSC

Diagram analysis

• The free-market equilibrium is at PeQe, where MPB = MPC

  • As MSC > MPC, there is a negative externality of production and output is above the socially optimal level (Qopt)

  • There is a pre-tax welfare loss (deadweight loss) shown by the shaded triangle

• A specific tax shifts supply left from S → S₁, where S₁ = MPC + tax

  • The new equilibrium is at P₁Q₁ — a higher price and lower output

  • Output moves closer to Qopt, reducing (but not necessarily eliminating) the welfare loss

  • The post-tax welfare loss is smaller than the pre-tax welfare loss

Ad valorem tax

• An ad valorem tax is a percentage of the purchase price

• Because the tax is proportional to price, the vertical distance between the original and shifted supply curve increases at higher prices - the two curves diverge

• Ad valorem taxes are widely used internationally:

  • Brazil operates one of the most complex ad valorem tax systems in the world, with multiple layers of federal taxes and state taxes on goods and services

  • India's Goods and Services Tax (GST) applies ad valorem rates of 5%, 12%, 18% or 28% depending on the good, with luxury and demerit goods attracting the highest rates

  • Most OECD countries apply a standard ad valorem consumption tax — for example, Japan's consumption tax is 10%, while many EU member states apply rates of 20–25%

Diagram analysis

• Initial equilibrium is at P₁Q₁

• The ad valorem tax shifts supply left from S → S + tax; the curves diverge because the tax per unit is larger at higher prices

• New equilibrium is at P₂Q₂ — price is higher and output is lower

• The tax burden is shared between consumers and producers:

  • Consumer incidence = (P₂ − P₁) × Q₂ — Area A

  • Producer incidence = (P₁ − P₃) × Q₂ — Area B

Specific vs ad valorem: key comparison

Evaluating the effectiveness of indirect taxation

Tax incidence and PED

• The division of the tax burden between consumers and producers depends on price elasticity of demand (PED) and price elasticity of supply (PES)

  • If demand is price inelastic, consumers bear most of the tax burden - price rises significantly but quantity demanded falls only slightly, limiting the reduction in output

    • Example: specific taxes on tobacco in Indonesia and China raise significant government revenue but have had limited success in reducing consumption because demand is highly inelastic

  • If demand is price elastic, producers bear more of the burden and output falls more significantly, which is more effective at correcting the market failure

Setting the correct tax rate

• To fully correct a negative externality, the tax must equal the marginal external cost (MEC) at the socially optimal output level

• In practice this is extremely difficult

  • External costs are hard to measure accurately

  • The socially optimal output level is unknown with certainty

  • Setting the tax too low leaves residual market failure; setting it too high creates a new welfare loss

  • Example: carbon taxes vary enormously across countries — Sweden's carbon tax is among the highest in the world, while many major emitting economies have no carbon tax at all, reflecting the difficulty of agreeing on the correct rate

Government failure

• If the tax is set incorrectly, it may worsen allocative efficiency rather than improve it - this is a form of government failure

• Higher taxes on demerit goods can encourage illegal markets:

  • Heavy tobacco taxation in Australia and Singapore has been linked to growth in illicit tobacco trade, partially undermining the policy's effectiveness

Equity

• Indirect taxes are often regressive - lower-income households spend a higher proportion of their income on taxed goods, so the tax burden falls disproportionately on them

• This is particularly significant in lower-income countries, where a larger share of household expenditure goes on basic goods that attract consumption taxes

• This creates a trade-off between efficiency and equity that governments must consider when setting tax rates

• Some governments attempt to address this by zero-rating essential goods such as food and medicine - common in many African and South Asian tax systems