Indirect taxes and subsidies: impact and incidence

Overview

Indirect tax, impact and the incidence of a tax and effects on consumers.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is an indirect tax, and how does a specific tax differ from an ad valorem tax?

   Model answer

   An indirect tax is a tax on spending, collected from producers or sellers but reflected in the price consumers pay. A specific tax is a fixed sum per unit, such as a set amount of duty on each litre of fuel, and it shifts the supply curve upwards by the same amount at every quantity, keeping the new curve parallel to the old. An ad valorem tax is charged as a percentage of the price, so the vertical gap between the curves widens as price rises and the supply curve pivots upwards rather than shifting in parallel.

2. 2

   Distinguish between the impact and the incidence of a tax.

   Model answer

   The impact of a tax is on whoever is legally required to hand the money to the government, which for an indirect tax is normally the producer or seller. The incidence is on whoever actually bears the burden through a higher price paid or a lower price received. The two differ because producers pass part of the tax on to consumers in the price, so the legal and the economic burden fall in different places.

3. 3

   Describe how a specific tax of a fixed amount per unit is shown on a demand and supply diagram, naming the axes and the areas.

   Model answer

   Put price on the vertical axis and quantity per period on the horizontal axis. Draw demand D and the original supply S1 crossing at P1 and Q1. Draw a second supply curve S2 parallel to S1 and vertically above it by exactly the amount of the tax, since producers now need that much more per unit. The new equilibrium is where S2 cuts D, at a higher price P2 and a lower quantity Q2. Producers keep P2 minus the tax, which can be read off S1 at Q2. Government revenue is the rectangle with height equal to the tax and width Q2, the consumer's share is the upper part of that rectangle above P1, the producer's share is the lower part below P1, and the triangle to the right, between D and S1 from Q2 to Q1, is the deadweight loss.

4. 4

   In a market where Qd = 120 − 2P and Qs = −30 + 3P, with P in pounds and Q in thousands of units, a specific tax of £5 per unit is imposed. Calculate the new equilibrium price and quantity.

   Model answer

   The tax means producers need £5 more per unit, so supply becomes Qs = −30 + 3(P − 5) = −45 + 3P. Setting this equal to demand gives 120 − 2P = −45 + 3P, so 165 = 5P and P = £33. Quantity is 120 − 2 × 33 = 54 thousand units. The price paid by consumers rises from £30 to £33 and the quantity traded falls from 60 to 54 thousand units.

5. 5

   With Qd = 120 − 2P, Qs = −30 + 3P and a specific tax of £5 per unit (P in pounds, Q in thousands), calculate the price producers receive and the government's tax revenue.

   Model answer

   The new equilibrium price paid by consumers is £33 and the quantity is 54 thousand units. Producers hand over £5 per unit, so they retain £33 − £5 = £28. Government revenue is the tax per unit multiplied by the quantity traded: £5 × 54 thousand = £270 thousand, or £270,000.

6. 6

   With Qd = 120 − 2P, Qs = −30 + 3P and a specific tax of £5 per unit (P in pounds, Q in thousands), calculate the share of the tax borne by consumers and by producers.

   Model answer

   Before the tax the price was £30. Consumers now pay £33, so they bear £3 per unit, and producers receive £28 instead of £30, so they bear £2 per unit. Consumers therefore bear £3 ÷ £5 = 60 per cent of the tax and producers 40 per cent. In total, consumers bear £3 × 54 thousand = £162 thousand and producers £2 × 54 thousand = £108 thousand, which together equal the £270 thousand of revenue.

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