Indirect Tax

Indirect tax

Indirect taxes are imposed by the government on the expenditure on to buy goods and services.

• they are paid to the government through producers

What are the 2 types of indirect tax?

1. excise tax: taxes on particular goods and services

2. taxes on spending on all/most goods and services

   1. eg: general sales tax in US

Direct taxes

Payment of taxes by the taxpayers directly to the government

Why do governments impose indirect taxes?

1. Source of government revenue

   1. In order to increase government revenue, indirect taxes are imposed on goods or services with price inelastic demand. This is because the increase in price will result in a proportionally lesser change in quantity demanded due to habits, less close substitutes, accounting for a lower percentage of income. –> higher total revenue for government budget to be spent on funds for other socially desirable services.

2. Decrease consumption of particular goods

   1. Indirect taxes can be placed on demerit goods (eg: tobacco, alchohol) or socially undesirable goods, as the higher prices will lower consumers real income (mostly for low income) / disincentivises consumers to purchase an additional unit as the ratio of utility gained to cost paid is lower.

3. Redistribute income

   1. In order to redistribute income, the government imposes specific taxes on luxury goods, as they account for a lower percentage of income to high income consumers. Hence, demand is price inelastic. As a result, the government can use the expenditure tax from the consumption of luxury goods to redistribute to lower income groups through transfer payments.

4. Improve allocation of resources

   1. By imposing a specific tax on goods and services that are undesirable for the counrty, it can help allow for more efficient allocation of resources.

      1. This is because the increase in price increases the cost of production as seen from the shift in supply curve. Quatity demanded also decreases as the higher prices disincentivises consumers to purchase. This signals to producers to reduce rationing of resources for the good, acting as a disincentitive → decreases output → shortaege → correct market failure

Does indirect tax increase or decrease allocative efficiency?

This depends on the degree of allocative efficiency before the indirect tax.

• If the economy begins with allocative efficiency, meaning that social surplus is maximized, the indirect tax would result in a decrease in supply of socially desirable goods → allocative inefficiency and welfare loss

• If the economy begins with allocative inefficiency, the indirect tax can help decrease consumption and production of the good or service, removing the source of inefficincy.

How might the general sales tax on all goods impact income distribution?

• This would increase price of normal and inferior goods , harming low income consumers as it lowers their real income → not be able to purchase these → income inequity

• To add on, since for high income consumers, normal and inferior goods account for a lower percentage of their income, they would be less willing to purchase these goods → unaffecting income distribution.

Specific taxes

A fixed tax per unit of the good and service sold

Draw and explain a diagram for a specific tax on alchohol

The specific tax causes an increase in price for alchohol from Pe to P1, increasing cost of production,thereby shifting the supply curve to the left from S1 to S2 = S1 + tax. As a result price paid by cosumers increases from Pe to P1, and price received by producers decreases from P1 to P3.

Later explain:

Welfare loss emerges due to a underallocation of resources relative to what is socially optimum (Q1<Qe). This can be seen through the decrease in social surplus, as consumer surplus decreases by area ____ since they are paying a higher price, and producer surplus decreases bc they r sellung at a lower price.

There is a increase in government revenue from tax as seen from (P2 - P1)xQ2.

Decrease in price recieved by producers to P2 = P1 - tax per unit , decrease in revenue to P2xQ1.

Increase in consumer expenditure from Pe x Qe to P1 x Q1.

What are the consequences of indirect tax on stakeholders?

1. Consumers

   1. Negative impact:

      1. Decrease in consumer surplus, have to pay a higher price than what they originally would have paid → significantly impacts low income consumers

      2. decrease in Qd is due to inefficiencies, as tehy pay a higher price and recicieve lower quantities

      3. decrease in cosnumer expenditure from Pe x Qe to P1 x Q1.

2. Producers

   1. Negative impact

      1. decrease in price recieved to P2 = P1 - tax per unit → due to decrease in Qd, signals to producers that consumers are less willing and able to purchase → decrease output

      2. decrease in output due to higher costs of production

      3. decrease in producer revenue

3. Workers

   1. Negative impact

      1. increase unemployment as the lower supply signals to producers to reduce labour to minimize costs

4. Government

   1. Gain

      1. They gain government revenue (P2 - P1)xQ1, to fund to other socially desirable goods and services

5. Society (Draw diagram)

   1. Gain

      1. decrease consumption of demerit goods or goods and services that harm the enviornment

   2. Loss

      1. Emergence of welfare loss due to underallocation of resources relative to what is socially optimum, leading to allocative inefficiency

         1. MB > MC

         2. decrease in social surplus.