4.1 Indirect Taxation

Question 1

Why do governments levy taxes?

Answer 1

Governments levy taxes for several reasons, including raising revenue to fund essential public expenditure and transfer payments, redistributing income, correcting market failures, and managing the macroeconomy.

Question 2

What is the purpose of raising revenue through taxation?

Answer 2

The purpose of raising revenue through taxation is to fund essential public expenditure and transfer payments. While governments can borrow a limited amount of money for this purpose, most of the finance must come from taxation to avoid inflation and excessive increases in national debt over time.

Question 3

What is the purpose of redistributing income through taxes?

Answer 3

The purpose of redistributing income through taxes is to reduce income inequality. If the government argues that the distribution of income is inequitable, it may impose or increase progressive taxation to reduce the income of some groups in society and use the money collected to increase the income of other groups.

Question 4

How can taxation correct market failures?

Answer 4

Taxation can correct market failures by reducing consumption and production of certain goods and services. Governments can introduce or raise taxes on cigarettes, carbon emissions, alcohol, etc. to discourage their consumption and production. In this way, taxation can be used to reach allocatively efficient outcomes in failing markets.

Question 5

What is the purpose of managing the macroeconomy through taxes?

Answer 5

The purpose of managing the macroeconomy through taxes is to influence variables such as growth, inflation, unemployment, and the current account. Governments may change tax rates to achieve these goals. For example, they may increase taxes during a period of high inflation to reduce aggregate demand or decrease taxes during a period of low growth to stimulate aggregate demand.

Question 6

How can taxation be used to influence growth?

Answer 6

Taxation can be used to influence growth by changing tax rates. Governments may decrease taxes during a period of low growth to stimulate aggregate demand and increase investment, consumption, and exports. This can increase economic activity and promote growth.

Question 7

How can taxation be used to influence inflation?

Answer 7

Taxation can be used to influence inflation by changing tax rates. Governments may increase taxes during a period of high inflation to reduce aggregate demand and discourage investment, consumption, and exports. This can decrease economic activity and reduce inflation.

Question 8

How can taxation be used to influence unemployment?

Answer 8

Taxation can be used to influence unemployment by changing tax rates. Governments may decrease taxes during a period of high unemployment to stimulate aggregate demand and increase investment, consumption, and exports. This can increase economic activity and create jobs, reducing unemployment.

Question 9

How can taxation be used to influence the current account?

Answer 9

Taxation can be used to influence the current account by changing tax rates. Governments may decrease taxes on exports to increase their competitiveness and promote exports, which can improve the current account balance. They may also increase taxes on imports to discourage their consumption and reduce import

Question 10

What is an indirect tax?

Answer 10

An indirect tax is a tax that increases a firm’s costs of production but can be transferred to consumers via higher prices. This tax shifts the supply curve in the market upwards from S1 to S1+tax, which increases the price of the product from P1 to P2, and reduces the quantity demanded from Q1 to Q2.

Question 11

Indirect Tax Diagram analysis

Answer 11

1) Supply Curve: Shifts upwards from $1 to S1+tax
2) Price & Quantity: Price increases from P1 to P2 and Quantity decreases from Q1 to Q2
3) Producer Revenue: Decreases from P1AQ10 to DCQ20
4) Government Revenue: P2BCD
5) Consumer Burden: P1P2BE
6) Producer Burden: P1ECD
7) Welfare Loss: ABC

Question 12

How does an indirect tax affect the supply curve?

Answer 12

An indirect tax shifts the supply curve in the market upwards from S1 to S1+tax. The vertical distance between the two supply curves reflects the value of the tax. This increases the cost of production for firms, which reduces the quantity supplied from Q1 to Q2.

Question 13

What is the burden of an indirect tax on consumers?

Answer 13

Consumers bear the burden of an indirect tax through higher prices. They pay a share of the tax P1P2BE, which reduces their consumer surplus. Indirect taxes are regressive, meaning they take a greater proportion of the poor’s income than they do of the rich, which could widen income inequality in society.

Question 14

How does the elasticity of demand affect the burden of the tax?

Eval Point

Answer 14

The elasticity of demand affects the burden of the tax. If the demand for the product is price inelastic, producers can transfer more of the tax onto consumers with there being a proportionately smaller decrease in quantity demanded, burdening low-income consumers the most. The opposite is true where demand is price elastic. In this case, the burden of the tax will fall more heavily on producers, knowing that increases in price would lead to large falls in total revenue.

Question 15

How can an indirect tax generate long-term benefits for consumers?

Eval Point

Answer 15

An indirect tax may generate long-term benefits for consumers if the revenue generated is spent on social goods and services in the economy, such as education, healthcare, and infrastructure. This could improve the lives of the poor, in particular, who rely more heavily on these services. Therefore, although consumers suffer short-term pain from the tax, there may be a long-term gain if the tax revenue is spent wisely.

Question 16

What is the effect of an indirect tax on de-merit goods?

Eval Point

Answer 16

If the government is looking to discourage consumption of a de-merit good, in this sense solving a market failure, it can be argued that burdening consumers is a weak argument as this is the exact intention of the policy. Reducing consumption, production and thus quantity in the market from Q1 to Q2 could well be reaching the socially optimum level of output increasing welfare in the market and not generating a welfare loss as the diagram suggests.

Question 17

How do producers suffer from an indirect tax?

Answer 17

Producers suffer from an indirect tax as it raises their costs of production, where they have to pay a share of the tax to the government indicated by the rectangle P1ECD. This leads to a fall in revenue from P1AQ10 to CDQ20. This could mean reducing the size of their workforces due to the lower quantity produced in the market to reduce their costs and remain profitable, impacting workers by increasing unemployment. If demand is price elastic, this argument is very strong. However, if demand is price inelastic, producers can transfer most of the tax burden onto the consumer without suffering such a large decrease in revenue. Workers may also not lose their jobs as quantity in the market will not decrease significantly.

Question 18

Why do governments impose an indirect tax?

Answer 18

The government will impose an indirect tax for two primary reasons: to raise revenue of P2BCD or to solve a market failure where overconsumption and/or overproduction exists. In this sense, the tax is in the government’s interests, benefiting in both ways. This allows for long-term spending on key areas of the economy such as health, education, and infrastructure. If this tax is implemented to solve market failure, the revenue could be used to further reduce consumption through advertising campaigns or subsidizing the production of better alternatives.

Question 19

What is the effect of an indirect tax on society’s surplus?

Eval Point

Answer 19

By burdening both consumers and producers heavily, there is a net loss of both consumer and producer surplus in the market, leading to an overall deadweight welfare loss of society surplus indicated by the triangle ABC. If the market was working efficiently, initially allocating scarce resources as socially desired, the government is now distorting that efficient allocation, generating a welfare loss causing government failure if the value of the loss exceeds the tax revenue gained. This argument is reduced, however, if the government has solved a market failure given a pre-existing misallocation of resources. In this sense, the government, in reducing quantity in the market, will increase society surplus, improving welfare in the market and the allocation of resources.

Question 20

What is the difference between a price elastic and inelastic demand?

Answer 20

Price elasticity of demand measures the responsiveness of quantity demanded to changes in price. A price elastic demand means that a small change in price causes a larger change in quantity demanded. In contrast, a price inelastic demand means that a change in price causes a proportionately smaller change in quantity demanded. If the demand for a product is price elastic, producers cannot pass on the entire tax burden to consumers, while if the demand is price inelastic, producers can transfer most of the tax burden onto the consumer.