💰 Indirect Taxes
Definition: An indirect tax raises the cost of production, shifting the supply curve LEFT (or upward by the amount of the tax).
Two types
- Specific tax — a fixed amount per unit (e.g. $1 per litre). S curve shifts UP by a parallel amount
- Ad valorem tax — a percentage of the price (e.g. 20% VAT). S curve shifts UP by an increasing amount (gap widens at higher quantities)
Effect on the market
- Supply shifts left/up → equilibrium price RISES, quantity FALLS
- Consumer pays a HIGHER price than before the tax
- Producer receives a LOWER price than before (net of tax)
- The difference between consumer price and producer price = the tax per unit
📊 Who Bears the Burden?
Tax Incidence: Tax incidence depends on which side of the market is MORE INELASTIC.
The elasticity rule
- Inelastic demand → consumers bear MORE of the tax (they keep buying despite higher price)
- Elastic demand → producers bear MORE of the tax (they cannot pass it on without losing customers)
- Inelastic supply → producers bear more. Elastic supply → consumers bear more
- Whichever side is MORE INELASTIC bears MORE of the tax burden
Cigarettes have inelastic demand (addiction). When the government imposes a tax, most of the burden falls on consumers — they pay a much higher price because they keep buying. This is why cigarette taxes generate enormous revenue.
On diagrams, show the tax as a vertical gap between S and S+tax. Shade the consumer burden (above old price, below new price) and producer burden (below old price, above new producer price) in different colours.
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⚖️ Welfare Effects of Taxes
- Consumer surplus DECREASES (higher price, lower quantity)
- Producer surplus DECREASES (lower price received, lower quantity sold)
- Government gains TAX REVENUE (tax per unit × quantity sold)
- But there is a DEADWEIGHT LOSS — the triangular area of lost surplus
Why governments use indirect taxes
- Raise revenue for government spending
- Reduce consumption of demerit goods (tobacco, alcohol, sugary drinks)
- Correct negative externalities (pollution taxes — see Topic 2.8)
- Redistribute income (can target luxury goods)
Taxes are REGRESSIVE if they take a larger proportion of income from the poor. Taxes on essentials (food, energy) can hurt low-income households disproportionately — an important evaluation point.