indirect taxes

• Indirect tax


  A tax imposed by the government that increases the supply costs faced by producers
• Types of indirect tax

  • Specific tax
  • Ad valorem tax
• Specific tax


  A set tax per unit e.g. a £5 tax per unit sold
• Ad valorem tax


  A percentage tax e.g. a 20% tax on the unit price
• The main UK indirect tax is VAT, which has a standard rate of 20%
• Specific tax effect


  1. Amount of tax shown by vertical distance between supply curves

  2. Tax causes inward shift of supply

  3. Increase in price

  4. Contraction of demand
• Specific tax effect


  • £1 per unit tax
  • Equilibrium price increases from £3.40 to £4
  • Producer absorbs 40p, consumer bears 60p
• Ad valorem tax effect

  1. Causes pivotal shift in supply curve

  2. Absolute tax amount increases as market price increases
• Elasticity of demand and supply

  More elastic demand or more inelastic supply, greater incidence of tax on producers, less on consumers
• Inelastic demand


  Higher tax revenue for government
• Elastic demand and supply


  Larger fall in quantity demanded, lower tax revenue for government
• UK has excise duties on alcohol, tobacco and petrol due to inelastic demand
• Incidence of tax


  • Paid by consumer
  • Paid by producer
• Perfectly elastic demand


  All incidence of tax absorbed by producer
• Perfectly inelastic demand


  All incidence of tax paid by consumer
• Perfectly elastic supply


  All incidence of tax paid by consumer
• Perfectly inelastic supply


  All incidence of tax absorbed by producer
• To ensure suppliers receive required minimum after indirect tax, market price must rise by full amount of tax
• Evaluation of indirect taxes

  • Effectiveness and unintended consequences
  • Revenue generation and use
  • Impact on businesses
  • Consequences for equity