Indirect taxes and incidence
Tax burden shared.
Indirect tax = tax on a transaction (goods/services), collected by the seller and passed to the government.
Two forms:
- Specific tax: fixed 0.50/litre on petrol). Supply curve shifts LEFT (or upward) by a CONSTANT amount.
- Ad valorem tax: percentage of price (e.g. 20% VAT). Supply shifts LEFT by a PROPORTIONAL amount — the shift fans out (larger absolute shift at high prices).
Effect on equilibrium:
- Equilibrium PRICE rises (consumers pay more).
- Equilibrium QUANTITY falls.
- Government collects revenue = tax × new Q*.
Tax incidence. Who bears the tax burden?
| Condition | Burden |
|---|---|
| Demand more inelastic than supply | Consumers bear MORE |
| Supply more inelastic than demand | Producers bear MORE |
| Both equally elastic | Burden split roughly evenly |
Worked example. Tobacco has very inelastic demand (addictive, few substitutes). A 1; smokers still buy.
In contrast, a tax on a luxury good with elastic demand: consumers cut back sharply; producers must absorb most of the tax to maintain sales.
Welfare effects of an indirect tax:
- Consumer surplus FALLS.
- Producer surplus FALLS.
- Government gains revenue (= tax × Q after).
- DEADWEIGHT LOSS: some trades that would have happened don't (small triangle of lost CS + PS not captured by gov't).
Rationales for indirect taxes:
- Raise revenue.
- Discourage demerit goods (tobacco, alcohol, sugary drinks).
- Internalise negative externalities (carbon tax).
- Specific tax: fixed/unit. Ad valorem: %.
- Incidence: more inelastic side bears more burden.
- Welfare: CS↓, PS↓, gov gain, deadweight loss.