1.4.1 Taxation Flashcards
What is a tax?
A charge levied by a government to raise revenue.
What are the two types of taxes?
- Direct taxes
- Indirect taxes
Direct taxes
Direct taxation is a type of tax which is paid for by an individual directly to the government.
Direct taxation is levied on income, wealth and profit.
For example:
- Income tax
- National insurance
- Corporation tax
Indirect taxes
An indirect tax is a tax on expenditure.charged on producers of goods and services and is paid by the consumer indirectly.
Some examples include:
- VAT
- Excise duties
- Customs duties
Give an example of how indirect taxes work.
For example, a bar of chocolate bought from Tesco would have VAT on it. The tax revenue does not go straight to the government, instead it is collected by the retailer (Tesco), who then pays it to the government.
What impact do indirect taxes have on the cost of production?
The indirect tax effectively increases to the cost of production as the producer has the responsibility to pay it. It will cause a reduction in supply (shifts left).
Two types of indirect taxes
- Specific
- Ad valorem
Specific taxes
The tax is a fixed amount that’s charged per unit of a particular good, regardless of the price of the good.
Ad valorem
The tax is proportion of the price of a good – meaning more expensive goods have higher taxes levied on them.
Specific tax diagram
A specific tax causes a parallel shift of the supply curve.
The tax is the same fixed amount at a low price (P1) and a high price (P2).
Ad valorem tax diagram
An ad valorem tax causes a non-parallel shift of the supply curve, with the biggest impact being on higher priced goods. The tax is a smaller amount at a low price (P1), compared to a high price (P2).
When are taxes used?
Governments often put indirect taxes on goods that have negative externalities, such as petrol, alcohol and tobacco.
Governments may use multiple indirect taxes on one item, e.g. in the UK cigarettes have a specific tax (called excise duty) and an ad valorem tax on their retail price.
What is the main aim of indirect taxes on demerit goods?
The aim of the indirect taxation of demerit goods is to disincentivise its consumption.
Additionally, it makes revenue for the government, which it can use to offset the effects of the externalities – e.g. the revenue generated from a tax on alcohol could be used to pay for the additional police time needed to deal with alcohol-related crime.
Advantages of indirect taxation
- The cost of the negative externalities are internalised in the price of the good – this works to disincentivise consumption/production of the good and therefore reducing the effects of the negative externalities.
- If demand isn’t reduced, the tax raised a sum of money, which the government can use to offset the externalities. E.g. a tax on cigarettes can be used for funding government services to help people to stop smoking.
Disadvantages of indirect taxation
- It can be difficult to put a monetary value on the ‘cost’ of the negative externalities.
- For goods where demand is price inelastic, the demand isn’t reduced by the extra cost of the tax.
- Indirect taxes usually increase the cost of production, which reduces a product’s international competitiveness.
- Firms may choose to relocate and sell their goods abroad to avoid the indirect taxation. This would remove their contributions to the economy such as the payment of tax and the provision of employment.
- Money raised by taxes on demerit goods may not be spent on reducing the effects of externalities.
Taxation shown on a diagram
The diagram shows the effect of an ad valorem tax – the supply curve moves up from S to S1.
In the diagram, the total tax paid is the whole rectangle. This is made up of the total tax paid by the consumer (shown in purple) plus the total paid by the consumer (shown in blue). The part of the tax paid by consumer is equal to the rise in price from P to P1. The part of the tax paid by the producer is equal to the difference between P2 and P1.
The amount of tax passed on to the consumer will depend on the PED:
- If demand for a good is price inelastic, most of the extra cost will be passed to the consumer.
- If demand for the good is price elastic, then the producer is much more likely to take on most of the extra cost.
what does the producer and consumer burden of an indirect tax look like
Things to talk about when discussing indirect taxes
- Government revenue
- Consumer Burden
- Producer revenue
- Producer burden
- Deadweight loss
Effect of indirect tax on consumers
Direct Effects:
Higher Prices: Indirect taxes (like VAT or excise duties) increase the price of goods/services.
Reduced Real Income: Consumers can afford less with the same income, reducing purchasing power.
Lower Consumption: Especially for price-sensitive goods (elastic demand), consumption may fall.
Evaluation:
If demand is inelastic (e.g. cigarettes, petrol), consumers bear most of the tax burden.
Regressive effect: Lower-income households spend a larger proportion of their income on taxed goods (inequitable impact).
Effect of indirect tax on producers
Direct Effects:
Increased Costs of Production: Leads to lower profit margins unless passed onto consumers.
Reduced Output: Can discourage production, especially if demand is elastic.
Competitiveness: Firms may become less competitive, especially in global markets.
Evaluation:
The burden depends on price elasticity of demand and supply:
If demand is elastic, producers absorb more of the tax to avoid losing customers.
May incentivize innovation or cost-cutting to maintain profit margins.
Effect of indirect taxes on government
Direct Effects:
Revenue Generation: Main benefit — provides a source of income for public services and infrastructure.
Can Correct Market Failures: Taxes on demerit goods (e.g., tobacco, alcohol) help internalize negative externalities.
Behavioral Change: Encourages consumers to shift to alternatives (e.g., sugar tax promoting healthier choices).
Evaluation:
Overreliance can be risky if demand is elastic — tax revenue might fall.
May face public resistance, especially if seen as unfair or poorly targeted.
