Introduction:

A tax on the value of a transaction, assessed as a percentage of price at the retail,

wholesale, and manufacturing stages. Examples of ad valorem taxes include the retail
sales tax in the United States, the value-added tax employed in Europe, and the purchase
tax levied in the United Kingdom. These are different from specific taxes or unit taxes,
which specify a flat sum per unit of product. Ad valorem taxes are often preferred to unit
taxes because they are considered less regressive. Moreover, their real value is not eroded
by inflation, whereas the unit tax remains constant as prices rise. An excise tax is a sales
tax on a specific item. An excise tax can be a per unit tax or an ad valorem tax. The first
is a fixed amount of tax per item, whereas the second is a percentage of the value of the
item. Excise taxes are a relatively minor source of revenue for most governments, but
they can be examined with simple diagrams and they illustrate problems that all taxes
have.
The picture below shows supply and demand diagrams for a competitive market with
constant marginal costs. With constant marginal costs, the supply curve will be a
horizontal line. Before any tax is imposed, q1 is the quantity sold and P1 is the price. A
per unit excise tax imposes a wedge between the price that the sellers see and the price
that the buyers see. In the graph the existence of this wedge is indicated by shifting up the
supply curve to "Supply with Tax." The "Supply" line shows how sellers react to the
prices they see, and the "Supply-with-Tax" line shows how the sellers react to the prices
that the buyers see.1

As a result of the tax, the equilibrium quantity is q2. Buyers pay a price of P2, but sellers
receive only a price of P1. The amount of revenue that the government collects is the tax
(P2-P1) times q2, or the wavy rectangle.
This figure illustrates two important results. First, consumers totally bear this particular
tax because the price rises by the full amount of the tax. This is true whether buyers or
sellers actually write the check that is sent to the government. If the sellers are legally
responsible for paying the check, the tax is totally shifted. This extreme result occurs
because of the peculiar way in which the supply curve is drawn--it is not a general result
of excise taxes.
Second, the tax causes a welfare loss or economic inefficiency because it prevents some
exchanges that could benefit both buyers and sellers. There are several ways to show this
cost. One is to use the concept of consumers' surplus. The loss of value to consumers is
the loss of consumers' surplus, the area a-c-d-b. The tax revenue, or area a-c-b-e,
represents that part of lost value government captures. The triangle c-d-e is a loss to the
consumers but it is not a gain to anyone else.
Another way of indicating that there is a welfare loss is to ask what happens to
consumers' costs and benefits if another unit beyond q2 in the graph above is produced.
The extra value of another unit is the distance from the demand curve to the horizontal
axis. The extra cost in terms of the value of resources that must be used is the distance
from the "supply" curve to the horizontal axis. Because this latter distance is less than the
former, consumers as a whole would benefit by greater production of the taxed item. But
this will not happen because the perceived marginal costs--which include the tax--are
greater than the actual marginal costs that include only the value of resources.

Abstract This paper shows that in a standard model of tax competition, the Nash
equilibrium in capital taxes depends on whether these taxes are unit (as assumed in the
literature) or ad valorem (as in reality). In a symmetric version of the model, general
results are established: taxes and public good provision are both higher, and residents in
all countries are better off, when countries compete in unit taxes, as opposed to ad
valorem taxes. However, the difference in equilibrium outcomes is negligible when the
number of countries is large.

What are indirect taxes?

An indirect tax is imposed on producers (suppliers) by the government. Examples include
excise duties on cigarettes, alcohol and fuel and also value added tax. Taxes are levied by
the government for a number of reasons – among them as part of a strategy to curb
pollution and improve the environment.
A tax increases the costs of a business causing an inward shift in the supply curve. The
vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit.
With an indirect tax, the supplier may be able to pass on some or all of this tax onto the
consumer through a higher price. This is known as shifting the burden of the tax and the
ability of businesses to do this depends on the price elasticity of demand and supply.
In the left hand diagram, demand is elastic meaning that demand is responsive to a
change in price. The producer must absorb most of the tax itself (i.e. accept a lower profit
margin on each unit sold). When demand is elastic, the effect of a tax is to raise the price
– but we see a bigger fall in equilibrium quantity. Output has fallen from Q to Q1 due to a
contraction in demand.
In the right hand diagram above demand for the product is inelastic and therefore the
producer is able to pass on most of the tax to the consumer through a higher price without
losing too much in the way of sales.
Who pays the tax? The burden of taxation
When demand is inelastic, the producer is able to pass on most or perhaps all of an
indirect tax to the consumer by raising the market price, conversely when demand is price
elastic, the producer cannot pass on much of the tax to the consumer, they must absord
the majot
Taxation, elasticity of demand and government revenue
The Government would rather place indirect taxes on commodities where demand is
inelastic because the tax causes only a small fall in the quantity consumed and as a result
the total revenue from taxes will be greater. An example of this is the high level of duty
on cigarettes and petrol.
The table below shows the demand and supply schedules for a good
Price (£) Quantity Demanded Quantity Supplied Quantity supplied
(Pre-tax) (Post-tax)
10 20 1280 600
9 60 1000 400
8 150 850 150
7 260 600 50
6 400 400
5 600 150
4 900 50

1 What is the initial equilibrium price and quantity? Price = £6

Quantity = 400
2 The government imposes a tax of £3 per unit. The new supply schedule is shown in the
right hand column of the table – less is now supplied at each and every market price
3 Find the new equilibrium price after the tax has been New price =£8
imposed
4 Calculate the total tax revenue going to the government Tax revenue = £450
5 How have consumers been affected by this tax?
There has been a fall in quantity traded and a rise in the price paid by consumers – this
leads to a fall in economic welfare as measured by consumer surplus

Specific taxes
A specific tax is where the tax per unit is a fixed amount – for example the duty on a pint
of beer or the tax per packet of twenty cigarettes. Another example is the air passenger
duty which imposes a standard tax of £10 for flights within the European Economic Area
(EEA) and £40 for flights outside of the EEA
Ad valorem taxes
Where the tax is a percentage of the cost of supply – the best example of this is value
added tax currently levied at the standard rate of 17.5% or Insurance Premium Tax which
is taxed at 5%.
In the diagram below, an ad valorem tax has been imposed on producers. The market
equilibrium price rises from P1 to P2 whilst quantity traded falls from Q1 to Q2.

Note that the effect of an ad valorem tax is to cause a pivotal shift in the supply curve.
This is because the tax is a percentage of the unit cost of supplying the product. So a
good that could be supplied for a cost of £50 will now cost £58.75 when VAT of 17.5%
is applied whereas a different good that costs £400 to supply will now cost £470 when the
 same rate of VAT is applied. The absolute amount of the tax will go up as the market
price increases.
Tobacco taxation is a good example of a product on which both specific and ad valorem
taxes are applied. The data below is taken from information produced by the UK
Customs and Excise and breaks down the taxation of cigarettes for a typical brand in the
mid-price category. Over the last ten years, the specific duty on cigarettes has nearly
doubled from 105 pence in 1994 to 200 pence after the March 2004 Budget. When we
add value added tax to the equation, the total tax on a standard packet of twenty cigarettes
has grown from 186 pence in 1994 to 365 pence in 2004. Cigarette taxation in the UK is
the highest among European Union nations. Total taxation as a percentage of the price
has remained fairly stable over the last decade at 80 – 81 per cent.
Taxation on Cigarettes
Typical Brand In Mid Price Category
(for a pack of 20 cigarettes)

Typical Pre-tax Specific Ad VAT Total Tax as % Specific

Price Price Duty Valorem Tax of Price Duty as % of
Duty Total Tax
1994 232 46.4 104.7 46.4 34.6 185.6 80.0 56.4
2000 367 66.4 165.2 80.7 54.7 300.6 81.9 55.0
2004 449 83.7 199.6 98.8 66.9 365.3 81.3 54.6

In recent years the government has encouraged a switch away from direct taxation on
income towards indirect taxes on the goods and services that we buy and then consume.
A wider range of indirect taxes has been introduced including the Insurance Premium
Tax, the Air Passenger Duty and the Landfill Tax.

Reference:

1) Department of Economics, University of Warwick, Coventry, CV4 7AL, UK