INDIRECT TAX

Question 1

Define direct tax:

Answer 1

A direct tax taxes the income of people and firms, which cannot be avoided.

Question 2

Define indirect tax

Answer 2

An indirect tax is one levied on expenditure on goods and services.

Question 3

Summarise workings of an indirect tax

Answer 3

Raises production costs causing decrease in supply,
Decrease in supply causes contraction of quantity demanded, price rises and quantity consumed falls
It corrects market failure by reducing the overconsumption
Also moves market equilibrium to the allocatively efficient level
Reduces welfare loss (triangle) due to negative externality.

Question 4

Summarise positives of an indirect tax in resolving market failure.

Answer 4

REVENUES
INCENTIVE TO IMPROVE, Maintain competitiveness of the price mechanism.
Increases productive efficiency?
Information provision / regulation may be better in case of demerit goods where PED is inelastic….
Where PED is inelastic—higher revenue from tax, and low opportunity cost of reducing size of industry since relatively low reduction in producer revenues.
HYPOTHECATION
BUT REMEMBER TO EXPAND AND APPLY THESE THEORETICAL POINTS.
— Depends on size and duration…
Alternative methods Information provision for demerit goods or Regulation

Question 5

Summarise negatives of indirect tax in resolving market failure

Answer 5

— Hard to quantify exact magnitude of the tax, which should equal size of negative externality.. IN case of demerit goods, even this is subjective and requires a value judgement (but the people who make the value judgement are more informed?)
— Producers may pass it onto consumers, and not reduce output if demand is inelastic, which may not resolve the normative view that the good is overconsumed.
– This also considerably lower consumer welfare by raising prices….
– — Taxes are ineffective in resolving overconsumption if demand is price-elastic PED<1.
–— Creates a loss of private consumer and producer surplus by raising price and lowering output
– — There’s an OPPORTUNITY cost in terms of output and industry size foregone, as well as a deadweight loss of private consumer welfare
— REGRESSIVE Taxation
— INTERNATIONAL CONSEQUENCES