Indirect Taxes
- An indirect tax is paid on the consumption of goods/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/services e.g education
- Indirect taxes are levied by the government on producers. This is why the supply curve shifts
- An indirect tax can be either ad valorem or specific
1. A Specific Tax
- A specific tax is a fixed tax per unit of output (specific amount) e.g. $3.25/packet of cigarettes
The impact of an indirect tax is split between the consumer (A) and the producer (B)
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
- 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
2. Ad Valorem Tax
- A tax that is a percentage of the purchase price e.g. Value added tax (VAT) in Columbia in 2022 was 19%
- The more goods/services consumed, the larger the tax bill
- This causes the second supply curve to diverge from the original supply curve
- VAT raises significant government revenue
A diagram showing an ad valorem tax (VAT) and the tax incidence for producers and consumers
Diagram Analysis
- Initial equilibrium is at P1Q1
- The government places an ad valorem tax to raise government revenue
- Supply shifts left due to the tax from S → S + tax
- The two supply curves diverge as a percentage tax means more tax is paid at higher prices
- Supply shifts left due to the tax from S → S + 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
- Final price of goods/service 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
Examiner Tip
When drawing this diagram, students often find it hard to identify the three price points.
The tax incidence boxes are formed by drawing the new equilibrium quantity through the original supply curve. The three price points are the old equilibrium point, the new equilibrium point - and where the new quantity crosses the original supply curve.
Irrespective if you are dealing with taxes or subsidies, always use the new equilibrium point to determine your incidence boxes.
The consumer incidence is paid from the consumer surplus area and the producer incidence is paid from the producer surplus area.