Indirect Taxes

Unit 4 - Lesson 2
Learning outcomes:
● Define all the terms appearing in orange bold in section 4.3 (AO1)
● Explain the consequences of indirect taxes on the stakeholders in the
market. (AO2)
● Draw diagrams to illustrate the the effects of indirect taxes on market
stakeholders. (AO4)
● Evaluate the effect of indirect taxes on markets and stakeholders. (AO3)
Introduction to Indirect Taxes
● Indirect taxes are imposed on the spending for good and services.
○ They are paid partly by the consumer, but are paid to the government by
the producer.
● Two types of Indirect Tax:
○ Excise tax
■ Tax on a specific good or service. For example, petrol and cigarettes
○ Taxes on all or mostly all goods and services:
■ General Sales Tax
■ Value Added Tax
Indirect Taxes and the Allocation of Resources
● Taxes have the impact of reallocating resources.
● From chapter 2, we learned that price changes act as a signalling and
incentive function in the market.
○ Indirect taxes (non-price determinant of supply) decrease the supply.
○ The decrease in supply results in an increase in price for the consumer resulting
in a decrease in the quantity demanded for the good.
○ Indirect taxes also result in a producer receiving a lower price resulting in a
decrease in quantity supplied of the good to the market.
● Thus by changing prices signals and incentives, indirect taxes impact the
allocation of resources.

Whether indirect taxes work to create more or less allocative efficiency in

the market depends on the degree of allocative efficiency that existed in the
market previous to the introduction of the tax.
Why Governments Impose Indirect Taxes
The reasons why governments impose indirect taxes were discussed and
expanded on in Unit 4 - Lesson 1.

The reasons are as follows:

1. Source of revenue for the government

2. Indirect taxes are a method a government can introduce to reduce the
consumption of socially undesirable/harmful goods.
3. Indirect taxes can be used to redistribute income.
4. Indirect taxes are a method to improve the allocation of resources (reduce
inefficiencies in the market) by correcting the Market Failure of Negative
Externalities of production and consumption.
Distinguishing between Specific and Ad Valorem Tax
Ad Valorem Tax:

● A fixed percentage of the price of a good

or service.
○ The amount of tax increases as the price
increases.
○ Ad Valorem Tax of 20%
■ Price = $10
■ Amount of tax paid = 10 X 20% = $2
■ Price = $20Amount of tax paid = 20
X 20% = $4

Thus as price increases the amount of tax

paid increases.
Distinguishing between Specific and Ad Valorem Tax
Specific Tax

● Fixed amount of tax paid per unit of

output.
● As quantity increases the amount of tax
per unit remains constant.
● Represented by a parallel shift of the
supply curve.

Summary:
Ad Valorem Tax - fixed percentage tax related
to price

Specific Tax - fixed tax related to quantity

Explain the consequences of indirect taxes on the stakeholders in the
market. (AO2)

Key terms to be familiar with:

● Amount of tax paid: amount of money paid on the output produced.

○ Represented by the vertical distance between S and S+tax
● Total Welfare Loss: the amount of consumer and producer surplus that is
lost due to the imposition of the tax.
● Consumer Burden: the amount of consumer surplus that is lost by the
consumer and transferred to the government.
● Producer Burden: the amount of producer surplus that is lost by the
producer and transferred to the government.
Explain the consequences of indirect taxes on the stakeholders in the
market. (AO2)

● Government Revenue: amount of money the government receives from

the imposition of the tax.
○ Calculated by multiplying the amount of per unit tax by the quantity of
output.
○ (Pc - Pp) X Q1
● Consumer Expenditure: the amount of money the consumer spends on a
specific amount of output.
○ Consumer Expenditure = Pc X Q1
● Producer Revenue: the amount of revenue earned for specific amount of
output produced.
○ Producer Revenue = Pp X Q1
Explain the consequences of indirect taxes on the stakeholders in the
market. (AO2)

Stakeholders in the market refer to the

following:

● Consumers
● Producers
● Government
● Society as a whole
● Workers - employment

How do indirect taxes impact each of

the stakeholders?
Explain the consequences of indirect taxes on the stakeholders in the
market. (AO2)
No Tax Tax Increase/ .
Decrease
PED < PES

PRICE Pe Pc Increase
CONSUMER

QUANTITY Qe Q1 Decrease

CONSUMER A+B+C+D A Decrease

SURPLUS

CONSUMER N/A B+C Increase

BURDEN

CONSUMER Pe X Qe Pc X Q1 Increase PED

EXPENDITURE < PES
Explain the consequences of indirect taxes on the stakeholders in the
market. (AO2)
From the graph and chart on the previous slide we can see how consumers are
impacted.

● Consumers pay a higher price (Pe - Pc)

● Consumers receive a smaller quantity (Qe - Q1)
○ How much smaller a quantity a consumer receives depends on their responsiveness
to the change in price (PED).
■ The larger the price elasticity of demand the smaller the quantity they receive.
● Consumer surplus decreases from A + B + C + D to A
● Consumer burden (the consumer surplus that is transferred to the government)
increases B + C

Consumers are worse off with the imposition of an indirect tax as they pay a
higher price and receive a smaller quantity of the good.
Explain the consequences of indirect taxes on the stakeholders in the
market. (AO2)
PED < PES NO TAX TAX INCREASE/D
ECREASE .

PRICE Pe Pp Decrease
PRODUCER

QUANTITY Qe Q1 Decrease

PRODUCER E+F+G+H H Decrease

SURPLUS

PRODUCER N/A E+F Increase

BURDEN

PRODUCER Pe X Qe Pp X Q1 Decreases
REVENUE
Explain the consequences of indirect taxes on the stakeholders in the
market. (AO2)
From the graph and chart on the previous slide we can see how producers are
impacted.

● The producer receives a lower price (Pe - Pp)

○ Producer receives Pc, however it must pay the tax (Pc - Pp) to the government which
results with them receiving Pp
● The producer sells a smaller amount of output (Qe - Q1)
○ How much smaller a quantity a producer sells depends on the consumers
responsiveness to the change in price (PED).
■ The larger the price elasticity of demand the larger the decrease in quantity.
● Producer surplus decreases from E + F + G + H to H
● Producer burden (amount of producer surplus transferred to the government) - E + F
● Producer Revenue decreases from Pe X Qe to P1 X Q1
○ The larger the PED the larger the decrease in total revenue.
Explain the consequences of indirect taxes on the stakeholders in the
market. (AO2)

PED < PES No Tax Increase/ .

Tax Decrease

Amount of N/A Pc - Pp Increase

Tax

Government N/A (Pc - Pp) X Q1 Increase

Revenue
B+C+E+F

The lower the PED for the good or service the greater
the amount of revenue received by the government.
● Reason: % change in price is greater than the %
change in quantity demanded.

The higher the PED the lower the amount of revenue

● Reason % change in price is less than the %
change in quantity demanded
Explain the consequences of indirect taxes on the stakeholders in the
market. (AO2)
Workers

● Since the quantity decreased from Qe - Q1 fewer workers are needed to produce
the goods.
● Therefore an increase in taxes may lead to an increase in unemployment.
● Workers are worse off.

Society:
● Assuming the market before the tax was allocatively efficient, then introducing
the tax results in an underallocation of resources to the production of the good.
● The decrease in quantity (Qe - Q1) results in a total welfare loss to society
(TWL) represented by the triangle (D + G).
● Society is worse off as a result of the tax