• An?indirect tax?is paid on the consumption of goods/services
  • It is only paid if consumers make a?purchase
  • It is usually levied by the government on?demerit goods?to reduce the quantity demanded (QD) and/or to raise?government revenue
  • Government revenue?is used to fund?government provision of goods/services?e.g education
• Indirect taxes can occur as a?specific?or?ad valorem?tax
  • They are levied by the government on?producers.?This?is why the supply curve shifts
• Producers and consumers?each pay a share (incidence) of the tax

The Incidence of a Specific Tax

A diagram that demonstrates the share of a specific tax paid by the consumer (A)
and the producer (B)

Diagram Analysis

• The government places a?specific tax?on a?demerit good
  • The supply curve shifts left from S1→S2?by the amount of the tax
• The?price the consumer pays has increased?from P1?before the tax, to P2?after the tax
• The?price the producer receives has decreased?from P1?before the tax to P3?after the tax
• The?government receives tax revenue?= (P2-P3) x Q2
  • The?consumer incidence?(share) of the tax is equal to?area A - (P2-P1) x Q2
  • The?producer incidence?(share) of the tax is equal to?area B - (P1-P3) x Q2
• The?QD?in this market has?decreased?from Q1→Q2
  • If the?decrease in QD?is significant enough, it may force producers to?lay off some workers

A Side by Side Comparison of The Impact of PED on Tax Incidence

• Aiming to maximise their profits,?producers?pass on?as much of the indirect tax as they can to?consumers?and pay the balance themselves
  • The amount?passed on?to consumers depends on the?price elasticity of demand (PED)?of the product

A diagram that demonstrates the tax incidence for a product whose PED is inelastic (left) and elastic (right). A is the consumer incidence and B is the producer incidence

Diagram Analysis

• In both diagrams, the?specific tax?shifts the?supply curve?from S1→S2
  • There is a?higher market price?at P2?and?lower QD?at Q2
  • Tax revenue?for the government is the sum of?A+B
  • Consumer incidence?is represented by A and?producer incidence?by B
  • Total revenue?for the seller is calculated using?P3?X Q2
• The?difference in PED?results in a?different steepness?to the demand curve
  • For an?inelastic product?(e.g., cigarettes), producers pass on a much?higher proportion of the tax to consumers?(A) and pay the rest themselves (B)
    • The?QD decreases?(Q1→Q2) but by a much?smaller proportion?than the increase in?price?(P1→P2)
  • For an?elastic product?(e.g., pizza), producers pass on a much?smaller proportion of the tax to consumers?(A) and pay the rest themselves (B)
    • The?QD decreases?(Q1→Q2) but by a much?larger proportion?than the increase in?price?(P1→P2)

• A?producer subsidy?is a?per unit?amount of money given to a firm by the government
  • To?increase production
  • To?increase provision?of a?merit good
• The?incidence?(share) of the?subsidy?is determined by the?PED of the product
  • If governments subsidies goods/services with high PED,?the increase in QD?will be?more than proportional?to the?decrease in price
  • Producers?keep some?of the subsidy and?pass the rest on?to the consumers

A diagram which demonstrates the cost of a subsidy to the government (A+B) and the incidence received by the?consumer (A) and producer (B)

Diagram Analysis

• The original?equilibrium?is at?P1Q1
• The?subsidy?shifts the supply curve from?S → S + subsidy:
  • This?increases the QD?in the market from?Q1→Q2
  • The?new?market?equilibrium?is P2Q2
  • This is a?lower price?and?higher QD?in the market

• Producers receive?P2?from the consumer?PLUS?the subsidy per unit from the government
  • Producer revenue is therefore?P3?x Q2
  • Producer incidence?of the subsidy is marked B in the diagram
• The subsidy?decreases the price?that consumers pay from?P1?→ P2
  • Consumer incidence?of the subsidy is marked A in the diagram
• The?total cost?to the government of the subsidy is?(P3?- P2) x Q2?represented by?area A+B