The effect of tax (Using the supply and demand curve)

Question 1

Indirect taxation

Answer 1

Indirect taxation is when the government places taxes on goods or services which increase a firms costs of production and therefore decrease supply to the market. These are split into 2 types:

• Specific - A fixed amount per unit such as a tax on cigarettes. Shown by a parallel inward shift in the supply curve because of the laws of supply
• Ad Valorem (VAT) -charged as a percentage of the price of a good or service - illustrated by an inward shift but with diverging supply curves (Not parallel - move further away as you go up the curve)

Question 2

How does PED affect taxation?

Answer 2

If a good is inelastic, (PED<1) A tax will have a smaller affect on consumption than if a good is inelastic. Unfortunately ,any good causing negative externalities that would be taxed are inelastic, such has cigarets and alcohol, so producers can get away with passing on most or all of the tax onto consumers.

Therefore indirect taxes are effective at rising revenue when demand is price inelastic, so the consumer burden is greater than the producer burden. This may lead to loss in welfare for the families of people consuming these goods, brining them closer to the poverty line.