Indirect taxes

Indirect taxes

Aim of imposing indirect taxes: the government does such spending in order to raise tax revenues and to internalise externalities, to achieve the optimum level of output.

A specific tax: a fixed amount of tax that is imposed on a product, which shifts the supply curve vertically upwards by the amount of tax. 

An ad valorem tax: the tax is a percentage of the selling price and so the supply curve will shift by an increasing amount as the price of the product rises.

When either specific taxes or valorem taxes are imposed, the market will shrink in size (decrease in quantity), thus possibly lower the level of employment in the market, since firms might employ fewer people. (Curve shifts up because it increases costs of production.)

Producer: revenue falls from P1Q1 to P3Q2.

Consumer: price per unit increases from P1 to P2

Tax burden for producers: Q2(P1- P3)

Tax burden for consumers: Q2(P2- P1)

Tax revenue for government: tax burden for consumers + tax burden for producers

Producers and consumers suffer: producers incur greater average costs, meaning that they partially pass this onto consumers

Tax reduces output: shifting supply to the left means a lower quantity is supplied, this means that the market size shrinks

Government benefits: taxes increase government revenue

Tax raises prices: tax shifts demand to the left and raises equilibrium, meaning higher prices