1.4.1 Taxation

Question 1

What is a tax?

Answer 1

A charge levied by a government to raise revenue.

Question 2

What are the two types of taxes?

Answer 2

• Direct taxes
• Indirect taxes

Question 3

Direct taxes

Answer 3

Taxes that go straight to the government from whoever is paying the tax.

For example:
- Income tax
- National insurance
- Corporation tax

Question 4

Indirect taxes

Answer 4

Taxes that involve an intermediary (retailer) to collect the tax before the government receives it.

Some examples include:
- VAT
- Excise duties
- Customs duties

Question 5

Give an example of how indirect taxes work.

Answer 5

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.

Question 6

What impact do indirect taxes have on the cost of production?

Answer 6

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).

Question 7

Two types of indirect taxes

Answer 7

• Specific
• Ad valorem

Question 8

Specific taxes

Answer 8

The tax is a fixed amount that’s charged per unit of a particular good, regardless of the price of the good.

Question 9

Ad valorem

Answer 9

The tax is proportion of the price of a good – meaning more expensive goods have higher taxes levied on them.

Question 10

Specific tax diagram

Answer 10

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).

Question 11

Ad valorem tax diagram

Answer 11

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).

Question 12

When are taxes used?

Answer 12

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.

Question 13

What is the main aim of indirect taxes on demerit goods?

Answer 13

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.

Question 14

Advantages of indirect taxation

Answer 14

• 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.

Question 15

Disadvantages of indirect taxation

Answer 15

• 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.

Question 16

Taxation shown on a diagram

Answer 16

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.