Indirect Taxes

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    An indirect tax is a tax levied on the sale of goods. An indirect tax increases a producer’s costs and causes a decrease in supply so the supply curve shifts left.

    A specific tax is levied as a fixed amount per unit of a good bought/sold. For example, a tax of £10 per unit. A specific tax is a fixed amount so it causes a parallel shift of the supply curve leftwards. A specific tax causes price to rise and output to fall.

    An ad valorem tax is levied as a percentage of the price of a good. For example, a tax of 20% on price. An ad valorem tax is a percentage on price, the monetary value of the tax rises as price rises, so the supply curve shifts and pivots leftwards. An ad valorem tax causes price to rise and output to fall.

    An indirect tax raises revenue for the government. A specific tax raises revenue equal to the red and blue areas.

    A producer is legally responsible for the statutory incidence of a tax if it is levied on the producer. But ‘tax shifting’ allows producers to make consumers pay some of the tax too. A specific tax shifts the supply curve left, raises price from P* to P’ and lowers output from Q* to Q’. A tax essentially raises the price paid by consumers and lowers the price received by firms. Consumers pay taxes equal to the red area because price is higher. Producers absorb and pay the rest of the tax equal to the blue area.

    The incidence of the tax depends upon the elasticities of demand and supply.

    A more elastic (inelastic) supply causes taxes to fall more on the consumer (producer).

    When supply is elastic, consumers pay the majority of the tax equal to the red area, producers pay taxes equal to the blue area.

    When supply is inelastic, consumers pay taxes equal to the red area, producers absorb the majority of the tax and pay the blue area.

    A more elastic (inelastic) demand causes taxes to fall more on the producer (consumer).

    When demand is elastic, consumers pay taxes equal to the red area, producers absorb the majority of the tax and pay the blue area.

    When demand is inelastic, consumers pay the majority of the tax equal to the red area, producers pay taxes equal to the blue area.

     

     

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