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Study notes

Indirect Taxes (Government Intervention)

  • Levels: AS, A Level, IB
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

An indirect tax is imposed on producers (suppliers) by the government. Examples include duties on cigarettes, alcohol and fuel and also VAT. A carbon tax is also an indirect tax. Indirect taxes are a form of government intervention in markets.

Examples of indirect taxes
PED and Indirect Taxes - Short Revision Video
  • VAT is a tax placed on the expenditure / a tax set as a percentage of the price of a good)
  • A tax increases the costs of production 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

Value added tax in the UK

  • The standard rate of VAT is 20%
  • Reduced rate of 5% is applied to domestic fuel and power, women’s sanitary products, children’s car seats, contraceptives
  • Zero-rated VAT on Food, Construction of new dwellings, rail and bus fares, books, newspapers and magazines, Children’s clothing, prescription drugs
  • Exempt from VAT - rent on domestic dwellings, Private education, Health service, Postal services, Burial and cremation, Small traders below the turnover limit for VAT registration

The table below shows the demand and supply schedules for a good

Price (£)

Quantity Demanded

Quantity Supplied

(Pre-tax)

Quantity supplied

(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 imposed

New price =£8

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

Indirect taxes - the importance of elasticity
Low and high price elasticity of demand

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.

  • 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 air passenger duty
  • Ad valorem taxes: Where the tax is a percentage of the cost of supply – e.g. value added tax currently levied at the standard rate of 20%. In the diagram below, an ad valorem tax has been imposed on producers. The equilibrium price rises from P1 to P2 whilst quantity falls from Q1 to Q2.
Value of cigarette duty in the UK

Problems with using taxes as a way of correcting for externalities and market failure

The aim of an indirect tax is to make the polluter pay and so internalise the externality. However implementing taxes is problematic:

  1. Setting the 'right' tax rate e.g. if the monetary value of a negative externality is hard to measure
  2. Cost of collection: e.g. road charging requires expensive infrastructure e.g. IT system of billing
  3. Inelastic demand: higher petrol prices via higher indirect taxes has little effect on demand for fuel, likewise, would a tax on sugar get people to cut their consumption of high-sugar products?
  4. Redistribution effects: Indirect taxes are regressive and affect low-income household most.
  5. Increased costs: Higher indirect taxes may cause inflation affecting consumers who did not pollute and international competitiveness if taxes are higher in one country than another

(Source: Richard Young, Transport Economics Q&A, Tutor2u, August 2013)

Ad valorem indirect taxes
Evaluation arguments with indirect taxes

Revision for other types of government intervention:

Evaluating Government Intervention in Markets - revision video

Quizlet revision activity on government intervention in markets

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