Indirect Taxation
Indirect tax
= tax upon expenditure, placed upon the selling price of the product
- should be paid by producers to the government, so it increases the costs of production.
- However producers will transfer some of the tax onto the consumers by increasing the price of
the product.
- Excise taxes = a tax per unit of product (parallel upward shift of the supply curve) on
particular goods/services (tobacco, alcohol, petrol)
Specific tax = fixed amount of tax per unit of a good
- Taxes on spending on ALL goods/services (E.g. VAT – 20%)
- Percentage taxes/sales tax = imposed upon the price of the product (non-parallel shift of
the supply curve)
- Indirect taxes are different from direct (taxpayers pay directly to the government)
Burden of tax = the amount of indirect tax paid to the government
Burden of tax is shared between producers and consumers, but not equally.
Indirect tax and Allocative Efficiency:
- Normally imposed on demerit goods
- They increase prices for consumers and costs of
production for firms
- They reduce both consumption and production
- Therefore change allocative efficiency
- If the economy starts with efficient allocation >> creates
allocative inefficiency
- If the economy has inefficient allocation >> can improve
allocative efficiency
Why the government imposes Indirect Tax?
1. Source of government revenue
2. Method of discouraging harmful consumption of demerit (harmful) products
3. Can redistribute wealth (tax on luxury products) – when rich pay these tax it reduces their
disposable incomes
4. Resource re-allocation by correcting negative externalities
However, a lot of indirect taxes are regressive and can worsen income inequality
- E.g. 2 individuals pay about 50 pounds in indirect tax on petrol.
- 1st individual earns 1000 pounds per month
- 2nd individual earns 5000 pounds per month
50
- Proportion paid out of income ( )x 100 = 5%
1000
50
- Proportion paid out of income ( ) x 100 = 1%
5000
- 1st individual loses a bigger proportion of income in tax
, Specific Tax Percentage (Ad
Valorem) Tax
CONSEQUENCES:
Consumers
pay higher price and
have less Q of good –
worse off
Firms
fall in revenues –
worse off
Government
improves the budget – better off
Workers
less Q, less workers needed
Society
under - allocation of resources to produce the good – worse off
Indirect taxes results in reduces consumer and producer surplus , part of which goes to
government revenue & part of which is a welfare loss. This is the result of resource
underallocation >> underproduction.
Triangles a + b represent social surplus lost as welfare loss
Indirect tax
= tax upon expenditure, placed upon the selling price of the product
- should be paid by producers to the government, so it increases the costs of production.
- However producers will transfer some of the tax onto the consumers by increasing the price of
the product.
- Excise taxes = a tax per unit of product (parallel upward shift of the supply curve) on
particular goods/services (tobacco, alcohol, petrol)
Specific tax = fixed amount of tax per unit of a good
- Taxes on spending on ALL goods/services (E.g. VAT – 20%)
- Percentage taxes/sales tax = imposed upon the price of the product (non-parallel shift of
the supply curve)
- Indirect taxes are different from direct (taxpayers pay directly to the government)
Burden of tax = the amount of indirect tax paid to the government
Burden of tax is shared between producers and consumers, but not equally.
Indirect tax and Allocative Efficiency:
- Normally imposed on demerit goods
- They increase prices for consumers and costs of
production for firms
- They reduce both consumption and production
- Therefore change allocative efficiency
- If the economy starts with efficient allocation >> creates
allocative inefficiency
- If the economy has inefficient allocation >> can improve
allocative efficiency
Why the government imposes Indirect Tax?
1. Source of government revenue
2. Method of discouraging harmful consumption of demerit (harmful) products
3. Can redistribute wealth (tax on luxury products) – when rich pay these tax it reduces their
disposable incomes
4. Resource re-allocation by correcting negative externalities
However, a lot of indirect taxes are regressive and can worsen income inequality
- E.g. 2 individuals pay about 50 pounds in indirect tax on petrol.
- 1st individual earns 1000 pounds per month
- 2nd individual earns 5000 pounds per month
50
- Proportion paid out of income ( )x 100 = 5%
1000
50
- Proportion paid out of income ( ) x 100 = 1%
5000
- 1st individual loses a bigger proportion of income in tax
, Specific Tax Percentage (Ad
Valorem) Tax
CONSEQUENCES:
Consumers
pay higher price and
have less Q of good –
worse off
Firms
fall in revenues –
worse off
Government
improves the budget – better off
Workers
less Q, less workers needed
Society
under - allocation of resources to produce the good – worse off
Indirect taxes results in reduces consumer and producer surplus , part of which goes to
government revenue & part of which is a welfare loss. This is the result of resource
underallocation >> underproduction.
Triangles a + b represent social surplus lost as welfare loss
