1.2.9 - Indirect Taxes

Question 1

Name two types of Taxes

Answer 1

. Direct Tax
. Indirect Tax

.

Question 2

Name two types of Indirect Taxes

Answer 2

. Ad Valorem Tax
. Specific / Unit Tax

Question 3

Define Direct Tax

Answer 3

. Tax imposed directly on an individual or organisation

. This is means it is imposed on income, wealth and profit

. The burden of a Direct Tax cannot be passed on

Question 4

Define Indirect Tax

Answer 4

. Tax on a good or service

. It is a tax imposed on the producers / suppliers

Question 5

Examples of Direct Tax

Answer 5

. Income tax
. Inheritance Tax
. National Insurance
. Capital Gains Tax
. Corporation Tax

Question 6

Examples of Indirect Tax

Answer 6

. VAT
. Excise Duties (Duties on Cigarettes, alcohol, fuel, air passenger)

Question 7

How does indirect tax affect supply?

Answer 7

. Indirect taxes increases cost of production to suppliers

. Due to tax, less is supplied at each price level, meaning there will be an inward shift in supply

. This results in an increase in the market price and a contraction in demand leading to a new equilibrium output

• Amount of tax is shown by the VERTICAL distance between the two supply curves

Question 8

Define Ad Valorem Tax

Answer 8

Tax imposed as a percentage of the value of the good

e.g. VAT is an example of Ad Valorem Tax. For example there may a 20% tax on the unit price

Question 9

Define Specific / Unit Tax

Answer 9

Set tax imposed on unit sold

e.g. Excise Duties are an example of a specific or unit tax e.g. £5 tax per unit sold

Question 10

Define Incidence of Tax

Answer 10

Refers to the extent to which an individual or organisation suffers from the imposition of tax

. It may fall on the consumer, producer or both

Question 11

Explain ‘Shifting the Burden’

Answer 11

. With an indirect tax, the supplier may be able to pass on SOME or ALL of this tax onto the consumer through a higher price

. This is called ‘shifting the burden’ of the tax.

. The ability of a business to do this depends on the price elasticity of demand and supply

Question 12

What does the extent to which tax incidence fall on consumers rather than producers depend on?

Answer 12

Price Elasticity of Demand and Supply

Question 13

Do you think the government would prefer to place an indirect tax on goods that have elastic demand or inelastic demand?

Answer 13

. If an indirect tax was put on an a good with inelastic demand, then it would mean that the supplier would pass on the cost of the tax to the consumers, meaning that the good would not be expensive. However, demand would not be heavily affected, since inelastic means demand is not as responsive. However, this means that consumer would have less disposable income and they would spent less money on other good, reducing demand and affecting GDP of an economy

. If the government, put an indirect tax on a good that has demand that is price elastic, it would been that the suppliers would pay most of the cost and not increase the price by a large amount. This is as demand is very responsive to price, meaning that an increase in price would reduce demand and affect total revenue. This may result in the quantity supplied for this good decreasing, since the cost of production increasing

Question 14

When does the incidence of tax fall wholly on producers?

Why?

Answer 14

. Supply is perfectly inelastic

OR

. Demand is perfectly elastic

Question 15

When does the incidence of tax fall wholly on consumers?

Answer 15

. Supply is perfectly elastic

OR

. Demand is perfectly inelastic

Question 16

Why does Ad Valorem Tax cause a pivotal shift in the supply curve?

Answer 16

. There is a pivotal shift in the supply curve, as the tax is a percentage of the unit of the cost of supplying the product

Question 17

Evaluation Arguments when Assessing Indirect Taxes

Answer 17

. Does an indirect tax generate substantial tax revenues

. Effect of a tax depends on Price Elasticity of Demand

. The regressive nature of VAT affects low income groups. Since, lower income groups spend a larger proportion of their income on consumption than higher income groups do, the burden of VAT is regressive. This affects low income groups by increasing wealth inequality

Question 18

Name 4 reasons why the government imposes taxes

Answer 18

. To raise tax revenues to fund their expenditure programmes —E.g. education. They can borrow a small amount of money, but most of the money must come from taxation. If they borrow too much money it could lead to inflation and increased national debt over time

. To redistribute income — if the government argues that distribution of income is unfair or unequal, to redistribute income, it may impose or increase progressive taxation to reduce income of some wealthier groups and use the money to increase the income of poorer groups

. To correct market failure — Governments can intervene in the market by introducing taxes to REDUCE consumption and production. This way the social welfare loss can be decreased and taxation can be used to reach allocatively efficiency in failing markers

. To manage macroeconomy — Taxation has an important influence on the macro - economic performance of an economy. Government may use taxes to influence variable such as growth, inflation, and the current account

Question 19

Explain how consumers are affected by the Indirect Tax

Evaluation

Answer 19

1.) Consumers suffer as a result of the indirect tax, as they pay a share of the tax due [Refer to area] to higher prices from P1 to P2.

. This REDUCES their consumer surplus.

. Additionally, the poor will suffer proportionately more than the rich as indirect taxes are REGRESSIVE, meaning that they take a greater proportion of the poor person’s income than they do of the rich

. This could widen the income inequality in society

2.) Consumers are burdened more if demand for the product is price inelastic. This is as producers know they can transfer more of tax onto consumers with there be a proportionately smaller decrease in quantity demanded. This burdens low income consumers the most.

The opposite occurs where demand in elastic. In this case, the burden of tax falls more on the producer, as they know that increasing price would lead to a fall in revenue

3. ) HOWEVER, although consumers suffer short term struggle with this tax, there may be LONG TERM gain. If the taxes generate enough revenue to improve social services in the economy, such as education and healthcare. This would improve the lives of the poor in the long term, even if the indirect tax is regressive.
4. ) Indirect taxes such as excise duties (type of unit / specific tax) on alcohol, can reduce overconsumption and overproduction of these goods with negative externalities. It can mean that goods are produce at the social optimum point (refer to government intervention power point )

Question 20

Explain how Indirect Taxes affect producers

Evaluation

Answer 20

1.) Producers suffer as the indirect tax raises their cost of production, meaning they have to pay a share of tax [Refer to area]. This reduces their PRODUCER surplus

This means that supply shifts inwards and there is a fall in revenue. This could mean that the size of the workforce is reduce due to lower quantity producer in the market to lower their costs of production. This increases unemployment

2.) The argument above is demand is price elastic. HOWEVER, if demand is price inelastic, then producers can transfer most of the tax burden onto the consumers without suffering a huge decrease in revenue. This way workers may not loses their jobs as quantity demanded in a market will not decrease significantly

Question 21

Explain how Indirect Taxes affects the Government

Evaluation

Answer 21

1.) A government imposes an indirect tax for TWO primary reasons: to solve market failure where overproduction and overconsumption exists and to increase revenue [Refer to area. Remember government revenue is the combination of the tax burden by producers AND consumers]

. This allows for long term spending on key areas of the economy such as healthcare and education. If the tax is implemented to solve the market failure of overconsumption and overproduction, it can be done through advertising campaigning

2.)HOWEVER, by burdening consumers and producers so heavily, the will be a loss of both consumer and producer surplus. There will be a loss of society surplus indicated by the triangle ABC. (Links in with evaluation for producer and consumer)

. Additionally, it could lead to market failure. If resources were already being allocated at social optimum point (allocatively efficiency), and the indirect tax was introduced, it could distort the efficient allocation generating a welfare loss. (Link to government failure)