Indirect Taxes

Indirect taxes: taxes (compulsory payment to the government) levied on expenditure on goods and services (eg. GST, VAT, custom duties and excises)

  • Raise firm’s costs and shifts supply curve vertically upwards by amount of tax

Types of taxes

  1. Specific (fixed amount) taxes are taxes that involve a flat tax per unit of good or service sold.
  2. Ad valorem (percentage tax) involves a tax of a fixed percentage of the price of good/ service sold. (As price increases, value of tax also increases).

Why do governments impose indirect taxes?

  1. Source of government revenue: the more inelastic demand, the greater the revenue
  2. Discourage the consumption of demerit goods: impact on price incentives and signals (increases price paid by consumers and producers, so they demand and produce less of the good)
  3. Correct negative externalities: improve allocation of resources 
  4. Protectionism
  5. Redistribution of income: collect tax revenue from luxury goods which is spent on things like healthcare and education which tend to benefit the poor

Market Outcomes of Indirect Taxes

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  • Increase in cost of factors of production
  • Equilibrium price increases from P* to Pc
  • Equilibrium quantity falls from Q* to Qtax
  • Consumer expenditure changes from P*Q* to PcQtax
  • Producer receives a lesser price from P* to Pp
  • Producer TR falls from P*Q* to PpQtax
  • Government tax revenue of Qtax (Pc – Pp)
  • Underallocation of resources (Qt < Q*)
  • Burden of indirect tax shared between consumers and producers




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