2.11 Government Intervention

Question 1

What is an indirect tax, and what is it purpose ?

Answer 1

• An indirect tax is a charge paid to the government based on the spending on a good and service
• its usual intended purpose is to reduce over-production/consumption (reduce market failure associated with de-merit goods and G/S which exhibit negative externalities)

Question 2

What is the effect of an indirect tax ?

Answer 2

• A tax usually increases costs of production for firms, an indirect tax is collected and payed to the government, hence increasing firms costs of production. This leads to a decrease in supply, increasing the market price and decreasing quantity traded
• if the tax corrects the market failure, resources will be allocated efficiently, social welfare will be maximised Q* = Q2

Question 3

What are the 2 types of indirect tax and how are they different ?

Answer 3

1) Specific tax - a certain fixed sum is payed to the government per unit of the G/S sold e.g Fuel duty is a specific tax
2) ad valorem tax - a tax applied as a percentage of the selling price of the G/S e.g VAT is charged as +20% of the selling price

Question 4

How can indirect tax’s correct market failure due to negative production externalities ?

Answer 4

• if the government’s objective is to fully correct the market failure, they need to set a level of tax = MEC, this makes the producer internalise the external costs by adding to private costs (polluter pays principle)
• if the level of tax is set at a level where the producer fully internalises the MEC, then quantity traded will equal Q*, no over-production/consumption, allocative efficiency is achieved and social welfare is maximised