Indirect taxes

• Indirect taxes


  Taxes on expenditure.
• Indirect taxes increase production costs for producers, so producers supply less. 


  This increases market price and demand contracts.
• Indirect taxes could be used to discourage the production or consumption of a demerit good or service.
• Two types of indirect taxes:

  1. Ad valorem; taxes are percentages (e.g. VAT)
  2. Specific taxes; set tax per unit
• Ad valorem is the main indirect tax in the UK.
• The incidence of tax (who ultimately pays what amount of tax - between the producer and consumer) depends on the price elasicity of demand of the good.
• Price inelastic means demand will not change as much with a price change so consumers are given the tax burden; price of the good being taxed rises and consumers pay the tax. This should discourage consumption of a demerit good and reduce negative externalities.
• TIP: When writing answers, apply theories to examples as a means of explaining, instead of just giving theoretical knowledge. E.g. demerit goods = cigarettes
• Government revenue from ad valorem taxes is larger if demand is price inelastic. This is because demand only falls slightly with the tax.
• Indirect taxes could reduce the quantity of demerit goods consumed, by increasing the price of the good.
• Indirect taxes can internalise an externality.