Tax Flashcards
What is indirect tax?
Indirect taxes are imposed on spending to buy goods and services. They are paid partly by consumers, but are paid to the government by producers (firms), and for this reason are called ‘indirect’. There are two types of indirect taxes:
1) Excise taxes - imposed on particular goods and services, such as petrol (gasoline), cigaretes and alcohol
2) Taxes on spending on all (or most) goods and services - such as general sales taxes (used in the United
States) and value added taxes (used in the European Union, Canada and many other countries).
When a tax is imposed on a good or service, it is paid to the government by the firm. This means that for every level of output the firm is willing and able to supply ot the market, ti must receive a price that si higher than the original price by the amount of the tax.
Indirect taxes and the allocation of resources
Taxes have the effect of changing the allocation of resources. Prices act as
signals and incentives, which determine the pattern of resource allocation. Since indirect (excise) taxes are imposed on particular goods, they increase the price paid by consumers, causing consumers to reduce their spending on taxed goods.
Excise taxes also lower the price received by producers, causing them to produce less. Therefore, by changing price signals and incentives, excise taxes affect the allocation of resources.
Do indirect taxes work to reduce or increase allocative efficency?
It depends on the degree of allocative efficiency in the economy before the tax is imposed.
If an economy begins with an efficient allocation of resources, the tax creates allocative inefficiency and a welfare loss.
In an economy with an inefficient resource allocation, indirect taxes potentially have the effect of improving resource allocation if they are designed to remove the source of allocative inefficiency.
Why governments impose indirect taxes?
1) Are a source of government revenue
2) Are a method to discourage consumption of goods that are harmful for the individual
3) Can be used to redistribute income - can focus on luxury goods
4) A method to improve the allocation of resources by correcting negative externalities
Ad-Valorem Vs Specific Tax
Specific taxes - A fixed amount of tax per unit of the good or service sold; for example, €5 per packet of cigarettes
Ad valorem taxes, a fixed percentage of the price of the good or service; in this case, the amount of tax increases as the price of the good or service increases. They have un parallel shift.
Consequences of tax on stakeholders
1) Consumers are negatively affected in two ways: by the increase in the price of the good (from P* to Pc, as shown in Figure 4.11(b)) and by the decrease in the quantity they can buy (from Q* to Q). Both of these changes make them worse off, as they are now receiving less of the good and paying more for it.
2) Producers(firms) are also negatively affected in two ways:
a) By the fall in the price they receive (from P* to Pp).
b) By the decrease in the quantity of output they sell (from Q* to Q). These effects result in a decline in their revenue, from P* × Q* before the tax to Pp × Q after the tax. Firms are therefore worse off as a result of the tax.
3) The Government: The government is the only stakeholder that benefits, as it gains revenue equal to (Pc - Pp) × Q, as shown in Figure 4.11(b). This is positive for the government budget.
4) Workers: The decrease in output from Q* to Q means that fewer workers are needed, which may lead to some unemployment. Workers who become unemployed are worse off due to the tax.
Society as a whole: consumer and producer surplus and welfare loss
The imposition of the indirect tax reduces consumer and producer surplus. Part of this reduction becomes government revenue, while the remainder results in welfare loss, as represented by the areas of triangles a and b. This welfare loss reflects the underallocation of resources to the good’s production, shown by MB > MC, indicating that too little is produced relative to the social optimum.
Consumer and Producer Surplus in a Competitive Free Market
We see the maximum consumer and producer surplus in a competitive free market without any taxes. This represents the maximum social surplus when there is no market intervention.
Effects of an Indirect Tax on Surplus (4)
An indirect tax impacts consumer and producer surplus in the following ways:
1) Consumer Surplus: Reduced to the shaded area under the demand curve and above the price paid by consumers (Pc) up to Q1.
2) Producer Surplus: Reduced to the shaded area above the supply curve (S1) and below the price received by producers (Pp) up to Q1.
3) Government Revenue: Part of the consumer and producer surplus is transformed into government revenue, shown as (Pc - Pp) × Q1.
4) Welfare Loss: Two triangular areas (a and b) represent the portion of social surplus lost due to the tax, as these areas are neither transferred to government revenue nor benefit consumers or producers.
Welfare Loss and Allocative Inefficiency
The welfare loss arises because the tax reduces the quantity produced to Q1, which is less than the optimal quantity (Q*). This underproduction of the good leads to an underallocation of resources, creating allocative inefficiency.
Marginal Benefits vs. Marginal Costs
At the new production level (Q1), MB > MC, indicating that consumers derive more benefit from the last unit of the good than it costs to produce it. This suggests that society would benefit if more of the good were produced, which is prevented by the tax.
Advantages of Tax
1) Raises the price and reduces the quantity demanded of demerit goods
2) Reduces external costs of consumption and production
3) Raises revenue for government programs
Disadvantages of Tax
1) The effectiveness of the tax in reducing the use of demerit goods depends on the price elasticity of demand (PED)
2) Many consumers who purchase products that are price inelastic in demand will continue to do so
3) It may help create illegal markets as consumers seek to avoid paying taxes
4) Producers may be forced to lay off some workers as output falls due to the higher prices
