Indirect Tax w/market failure

• Indirect taxation


  Taxes and increases of firms' costs of production that can be transferred to the consumer via a higher price
• Using indirect taxation to solve market failure

  • Addresses overconsumption and not overproduction
  • Addresses negative externalities in production or consumption (demerit goods)
• How indirect taxation solves negative externality in production

  1. Increases firm's costs of production

  2. Shifts MPC curve to the left

  3. Equilibrium shifts to Q* where MPC = MSC
• How indirect taxation solves negative externality in consumption

  1. Increases firm's costs of production

  2. Shifts MPC curve to the left

  3. Equilibrium shifts to Q* where MPC = MPB
• Indirect tax increases costs of production for firms, shifting the MPC curve
• Indirect tax leads to higher prices and lower quantities, internalizing the externality
• Government revenue from indirect tax

  Vertical distance between old and new MPC curves, multiplied by quantity sold
• Government revenue from indirect tax can be used to further solve the market failure
• Issues with using indirect taxation to solve market failure

  • Assumes price elastic demand
  • Assumes government has perfect information to set tax at optimal level
  • Can lead to black markets and smuggling
  • Can be regressive, hitting the poor harder
  • Can be paternalistic, impinging on individual freedom and choice
• Indirect taxation can lead to government failure if not implemented correctly