Indirect tax

What is indirect tax?

An expenditure tax that increase a firm’s cost of production but can be transferred to consumers via higher prices.

Why do governments levy taxes?

• To raise revenue to fund essential public expenditure and transfer payments.

• To redistribute income, and therefore may impose or increase progressive taxation to reduce income of some goods in society to increase the income of some other groups.

• To correct market failures such as cigarettes or alcohol overuse.

• To manage the macroeconomy and influence variables such as growth, inflation, unemployment and the current account.

• To protect domestic firms from foreign competition through tariffs.

Explain the diagram of indirect tax.

An indirect tax that increases a firm’s costs of production can be transferred to the consumers through higher prices. An indirect tax will therefore shift the supply curve to the left from S1 to S1+Tax as it increases the cost of production for firms. The vertical difference between the two supply curves reflects the value of the tax. This increases the price of the product from P1 to P2 and due to the law of demand, where a higher price discourages consumption, quantity falls from Q1 to Q2.

How will indirect tax affect consumers?

Consumers suffer as a result of the indirect tax, paying a share of it due to the higher prices, reducing their consumer surplus. The poor will suffer proportionately more than the rich however as indirect taxes are regressive, meaning they take a larger proportion of the poor’s income than they do of the rich which could widen income inequality in society.

Please provide evaluation points for how indirect tax will affect consumers.

• Consumers are burdened even more if the demand for the product is price inelastic due to being either a necessity or potentially addictive in nature. Therefore, the producers know they can transfer more of the tax onto consumers, burdening low income consumer the most. But if a product is price elastic then the burden on the tax will fall more heavily on the producers.

• Consumers suffer short term pain from this tax, but there may be glong term gain if such taxes generate enough revenue for there to be greater spending on public services.

How would an indirect tax affect producers and workers?

Producers suffer as this tax raises their costs of production where they have to pay a share of the tax to the government, leading to a fall in revenue. This could mean reducing the size of their workforce as labour is a derived demand and firms will want to decrease costs of production.

Please evaluate the effect indirect tax will have on producers and workers.

• This will only occur if demand is price elastic. If demand is price inelastic producers can transfer most of the tax burden onto the consumer without suffering such a large decrease in revenue. Workers may also not lose their jobs as quantity in the market will not decrease significantly.

How will indirect tax affect the government?

They will impose an indirect tax to raise revenue or to solve market failure where overconsumption or overproduction exists. This allows for long term spending on key areas of the economy such as health, education and infrastructure.

Please evaluate the effect of indirect tax on the government?

By burdening both consumers and producers so heavily, there is a net loss of both producer and consumer surplus in the market leading to an overall deadweight welfare loss of society. If the market was working efficiently, initially allocating scarce resources as socially desired, the government is now distorting that efficient allocation generating a welfare loss causing government failure if the value of the loss exceeds the tax revenue gained.But this argument is reduced if the government has resolved a market failure.