1.3 Taxes

Note: the example and the diagrams used in this example where extracted from Economics for the IB Diploma by Ellie Tragakes (Published by Cambridge). 

Learning outcomes

• Indirect taxes
• Why does the government impose indirect(excise) taxes
• Specific vs ad valorem taxes
• Diagrams for specific and ad valorem taxes and analyse the impact on market
• Consequences of imposing excise taxes on government, consumer and producer
• Explain, using diagrams, how the incidence of indirect taxes on consumers and firms differs, depending on the price elasticity of demand and on the price elasticity of supply. (HL)
• Plot demand and supply curves for a product from linear functions and then illustrate and/or calculate the effects of the imposition of a specific tax on the market (on price, quantity, consumer expenditure, producer revenue, government revenue, consumer surplus and producer surplus). (HL)

Indirect tax

These are taxes imposed on the producer for producing a good are services but they are passed onto the consumer aswell depending upon the elasticity of the good or service.

Why does the government impose these tax?

• Source of government revenue. If the demand for the product on which the excise tax is imposed is inelastic, government is almost guaranteed a fixed revenue.
• Discourage consumption of goods that are harmful. This includes drugs and alcohol. The effectiveness of discouraging consumption like this depends on the price elasticity of the good. Also, discouraging like this mostly works on the part of population which have less disposable income.
• Redistribute income. Imposing taxes on luxury items that mostly, high income population purchases. The revenue generated from these goods can be spent on the poor population.
• Improve allocative efficiency. The tax can be used to improve allocative efficiency in case if there are negative externalities.

Types of taxes

Specific vs ad valorem tax

Specific – fixed amount per unit of good or service. Both the supply curves are parallel to each other.

Ad valorem – fixed % of the price of good or service.

Impact of taxes

The diagram shows supply and demand of stimples (a product) the supply and demand are both almost unit elastic (although slightly inelastic). The supply and demand are given by the following equations.

Qd=60-2P

Qs=-4+2P

In this diagram we can see,

• Because of the tax, the supply curve has shifted up to make a new supply curve s2
• The new equilibrium is at Pc and Qt, the price is now higher and less of quantity is supplied

Below is how to calculate the following.

Change in Consumer expenditure

This is the total amount money spent by all the consumers.

consumer expenditure =quantity x price

Consumer expenditure before tax

60 - 2p = -4 + 2p

4p = 64

p = 16

q = 60-2(16)

q = 28

28 x 16 = 448

Consumer expenditure after tax

A new supply function can be formed, by just subtracting the total tax from the p in the supply equation. Notice how only the supply equation changes as tax only affects the supply.

60 - 2p = -4 + 2(p-6)

60 - 2p = -4 + 2p - 12

76 = 2p + 2p

4p = 76

p = 19

q = 60 - 2(19)

q = 22

19 x 22 = 418

Change

448 - 418 = 30

Here we see a fall in consumer expenditure. This is because the demand and supply is elastic. If the demand where have been inelastic, there would have been an increase in consumer expenditure.

Equations of demand and supply can be used to calculate the same.

Producer revenue

revenue =quantity sold price received

Before tax

16 x 28 = 448

After tax

13 x 22 = 286

Change

448 - 286 = 162

Fell by 168

Government Revenue

gov revenue = taxquantity

6 x 22 = 132

Notice, this is equal to the difference in consumer expenditure and producer revenue after tax.

418 - 286 = 132

Consequences/Benefits of indirect taxes

To consumer

• The tax increases the price of the good and now less of quantity is  available. Hence tax is disadvantageous to consumers.

To Producer

• They will experience a fall in price received and quantity sold. This means less revenue. Hence, tax is disadvantageous for to the producer.

Government

• Government benefits as they receive revenue.