An introduction to taxation

Any of the factors which may shift supply and demand will lead to a change in price of a good or service. The role of indirect taxes and subsidies in influencing price is now considered in more detail.

Indirect taxes

A tax is a compulsory charge made by the government, on goods, services, incomes or capital. The purpose is to raise funds to pay for govern,ent spending programmes. There are two types of tax: direct and indirect.

A direct tax is levied directly on an individual or organisation. Direct taxes are generally taxes on incomes: for example, personal income tax and corporation tax (on company profits).

An indirect tax is usually levied on the purchase or goods and services. It represents a tax on expenditure. There are two types of indirect tax: specific and ad valorem taxes. A specific tax is charged as a fixed amount per unit of a good such as a litre of wine or a packet of cigarettes. An ad valorem tax is charged as a percentage of the price of a good: for example VAT of 17.5% is added on to restaurant meals.

The imposition of an indirect tax raises the price of a good or service. The tax is added to the supply price, effectively causing the supply curve to shift vertically upwards and to the left (a decrease in supply). A specific tax causes a parallel shift of the supply curve to the left, as shown in part (a) of the following diagram. An ad valorem tax causes pivotal rotation of the supply curve to the left, as shown in part (b).

[diagram on page 33]

The incidence of taxation

The tax incidence usually falls partly on consumers and partly on producers, depending on the relative price elasticities of demand  and supply for the good or service. A combination of the price inelastic demand price elastic supply tends to place most of the tax burden of consumers addictive good such as tobacco and alcohol tend do this. This means that firms are able to pass most of the burden onto consumers via higher prices.

However, a combination of price elastic demand and price inelastic supply tends to place most of the tax burden on the producers. It may also lead to significant reduction in output and employment. Consequently, a government may be reluctant to place high indirect tax on thee goods or services.

The figure below shows the effects of a specific tax on a good that is price inelastic in demand. Before the tax, equilibrium price is Pe and quantity Qe. After the tax is imposed, the supply curve shifts to S1 and the equilibrium price rises to P1m while quantity falls to Q1. The total tax area is XYWP1.

The incidence of tax paid by consumers is shown by the actual rise in market price from Pe to P1. Consumers pay the amount of tax shown by the area XZPeP1. The tax paid by producers is ZYWPe.

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