Indirect Taxes (Cambridge (CIE) A Level Economics): Revision Note

Indirect taxes

• An indirect tax is paid on the consumption of goods or services

  • It is only paid if consumers make a purchase

  • It is usually levied by the government on demerit goods to reduce the quantity demanded (QD) and/or to raise government revenue

  • Government revenue is used to fund government provision of goods and services, e.g., education.

Specific tax on negative externality of production

• A specific tax is a fixed amount of tax per unit of output (e.g. £2 per unit)

  • This differs from an ad valorem tax, which is a percentage of the price

• Governments frequently tax firms that pollute or create harmful external costs in production

Diagram analysis

• The free-market equilibrium is at P_eQ_e - where MSB = MPC

  • Market failure exists as MSC > MSB at equilibrium

  • The optimum level of output is at Q_opt

  • There is over-provision of this product

• A specific tax shifts the supply curve left from S → S₁

  • The tax does not completely eradicate the welfare loss but moves the market closer to the optimum level of output (Q_opt)

  • The welfare loss has been reduced as shown in the diagram

• The new market equilibrium is at P₁Q₁

  • This is a higher price and less output

  • There is less over-provision and so less market failure

  • The external costs have been reduced

• Governments frequently tax the production of goods and services that create environmental harm or damaging health consequences

  • Some examples include intensive factory farming, oil drilling, the manufacture of chemicals and the construction of new roads or runways at airports

Incidence of a specific tax

• A specific tax is a fixed tax per unit of output (specific amount) e.g. $3.25/packet of cigarettes

 Diagram Analysis

• Initial equilibrium is at P₁Q₁

• The government places a specific tax on a demerit good

  • The supply curve shifts left from S₁→S₂ by the amount of the tax

• The price the consumer pays has increased from P1 before the tax, to P2 after the tax

• The price the producer receives has decreased from P1 before the tax to P3 after the tax

• The government receives tax revenue = (P₂-P₃) x Q₂

• Producers and consumers each pay a share (incidence) of the tax

  • The consumer incidence (share) of the tax is equal to area A: (P₂-P₁) x Q₂

  • The producer incidence (share) of the tax is equal to area B: (P₁-P₃) x Q₂

• New equilibrium is at P₂Q₂

  • The final price is higher (P₂) and QD is lower (Q₂)

  • If the decrease in QD is significant enough, it may force producers to lay off some workers

PED and tax incidence

• Aiming to maximise their profits, producers pass on as much of the indirect tax as they can to consumers and pay the balance themselves

  • The amount passed on to consumers depends on the price elasticity of demand (PED) of the product

Diagram analysis

• In both diagrams, the specific tax shifts the supply curve from S₁→S₂

  • There is a higher market price at P₂ and lower QD at Q₂

  • Tax revenue for the government is the sum of A+B

  • Consumer incidence is represented by A and producer incidence by B

  • Total revenue for the seller is calculated using P₃ X Q₂

• The difference in PED results in a different steepness to the demand curve

  • For a price inelastic product (e.g. cigarettes), producers pass on a much higher proportion of the tax to consumers (A) and pay the rest themselves (B)

    • The QD decreases (Q₁→Q₂) but by a much smaller proportion than the increase in price (P₁→P₂)

  • For a price elastic product (e.g. pizza), producers pass on a much smaller proportion of the tax to consumers (A) and pay the rest themselves (B)

    • The QD decreases (Q₁→Q₂) but by a much larger proportion than the increase in price (P₁→P₂)