INDIRECT TAXES

An indirect tax is a tax on the expenditure on goods.  These are taxes paid by
the seller of the good, who usually asks the consumer to pay some or all of it.


Specific taxes are indirect taxes where a fixed sum is paid per unit sold.
Examples of such taxes in the UK are excise duties on tobacco, alcoholic
drinks and petrol.


Ad valorem taxes are indirect taxes where a certain percentage is added on to
the price of each unit sold.  A UK example is Value Added Tax (VAT) currently
standing at 17.5%.


A subsidy is a grant given by the government which is usually a fixed sum
granted per unit sold.

EFFECT ON SUPPLY CURVES OF THE DIFFERENT INDIRECT
TAXES

As seen in the section on supply, taxes have the effect of raising costs of 

production a thereby shifting the supply curve to the left.  For a specific tax 

this will mean that the shift will be a parallel one because the amount of tax is 

the same at all prices, the vertical distance between the supply curves will 

give the amount of specific tax.  For an ad valorem tax the curve will swing to 

the left, because the amount of tax per unit increases as prices get higher, 

thereby widening the gap between the pre tax supply curve and the post tax

supply curve.  This situation is shown on the diagrams below:

THE INCIDENCE OF TAXATION

The incidence of taxation is the burden of tax shared between buyers and 

sellers.

The following diagram shows how this is worked out:

The specific tax per unit is shown as the vertical distance (t) between the two 

supply curves.  The price to the consumer has risen to P2 and output of the 

good has fallen to Q2.  The incidence or burden for the consumer can be 

calculated as the change in price multiplied by the quantity of the good 

consumed, this gives the area P1P2ab.  The total government revenue from 

the tax can be found by multiplying the specific tax per unit (t) by the quantity 

bought/sold Q2 this gives the area P2-tP2ac.  That part of the government 

revenue not paid by the consumer must therefore have been paid by the 

producer and producer contribution is P2-tP1bc. 

The total government’s tax revenue is equal to the specific tax per unit 

multiplied by the equilibrium output after tax. 

The consumer’s tax burden or incidence is equal to the change in price 

multiplied by the equilibrium output after tax.  It is the top portion of the 

government’s revenue. 

The producer’s tax burden is equal to the area of the government’s tax 

revenue which is not paid by the consumer.  This is the bottom portion of the 

government’s tax revenue. 

TAX INCIDENCE AND ELASTICITY

When demand is inelastic the consumer’s tax burden is greater than the 

producer’s.

When demand is elastic the producer’s tax burden is greater than the 

consumer’s.

When supply is elastic the consumer’s tax burden is greater than the 

producer’s. 

When supply is inelastic the producer’s tax burden is greater than the 

consumer’s.

The relationship between elasticity and tax incidence is exactly when an ad 

valorem tax is levied on goods.

FURTHER OBSERVATIONS

Government’s tend to impose specific taxes on alcohol, petrol and cigarettes 

the reasons for this are: 

Demand will be relatively unaffected and so firm’s will lose little in the way of 

revenue.

Government’s revenue is highest when taxing goods with inelastic demand. 

Recent governments have tried to persuade consumers to use less of these 

goods for health/environmental reasons.