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
- Specific (fixed amount) taxes are taxes that involve a flat tax per unit of good or service sold.
- 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?
- Source of government revenue: the more inelastic demand, the greater the revenue
- 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)
- Correct negative externalities: improve allocation of resources
- 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
- 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