Types of indirect taxes and their effects on supply

Indirect taxes are charges applied to the sale of goods or services, which raise production costs for firms. These taxes differ from direct taxes, such as income tax, which are levied directly on individuals or organisations based on their earnings.

The two main types of indirect taxes

• Specific taxes - These involve a fixed charge per unit of the good, regardless of its price. For instance, a flat fee might be added to each litre of fuel, applying equally to low-cost and high-cost options.
• Ad valorem taxes - These are calculated as a percentage of the good's price. For example, a 15% tax on an item costing £20 would add £3, while the same tax on a £200 item would add £30.

How indirect taxes shift the supply curve

Indirect taxes increase the expenses faced by producers, leading to a leftward shift in the supply curve as firms supply less at each price level. The nature of the shift varies by tax type.

Effects of a specific tax on supply:

• A specific tax results in a parallel leftward shift of the supply curve.
• The vertical gap between the original and new supply curves remains constant at all price levels, reflecting the fixed tax amount.
• For example, at a lower price like £7 or a higher price like £22, the tax added is the same fixed sum, reducing the quantity supplied equally across prices.

Effects of an ad valorem tax on supply:

• An ad valorem tax causes a non-parallel leftward shift, with the supply curve pivoting upwards from the origin and becoming steeper.
• The vertical gap widens at higher prices, as the tax represents a larger absolute amount on more expensive goods.
• For instance, the tax impact is smaller at a low price like £12 compared to a high price like £60, disproportionately affecting higher-priced items and reducing supply more at those levels.

Use of indirect taxes on goods with negative externalities

Governments frequently apply indirect taxes to products that generate negative externalities, which are harmful spillover effects on third parties not involved in the transaction. This approach aims to make producers or consumers accountable for these external costs.

Examples of taxed goods and combined taxes

Common targets include items like fuel, alcoholic drinks, and cigarettes, which contribute to issues such as pollution, health problems, and social disorder. In some cases, governments combine taxes on a single product; for example, cigarettes might face both a specific tax (a fixed excise duty per pack) and an ad valorem tax based on their selling price.

Aims of taxing goods with negative externalities

The primary goal is to internalise the externality by incorporating the social costs into the product's price, encouraging reduced consumption or production. Revenue from these taxes can fund measures to counteract the harms, such as using alcohol tax proceeds to support policing for drink-related incidents.

Case study: Landfill tax as a specific tax

Landfill tax serves as an environmental specific tax in places like the UK.

It is designed to address the negative externalities of waste disposal:

• Application of the tax - Councils or businesses pay a fee per tonne of waste sent to landfill sites, set at a level that approximates the full social costs, including pollution from methane emissions or groundwater contamination.
• Encouragement of alternatives - The tax promotes recycling and waste reduction, potentially decreasing environmental damage from landfills.
• Unintended consequences - However, it has sometimes led to illegal activities like fly-tipping, where waste is dumped unlawfully on unauthorised sites such as farmland or verges to evade the charges.

How diagrams show total tax paid and tax incidence

Supply and demand diagrams can illustrate the effects of indirect taxes, including how the tax burden is shared between consumers and producers. This sharing, known as tax incidence, depends on factors like price elasticity of demand (PED).

Key features of a tax diagram

Consider a diagram with a downward-sloping demand curve (D) and an upward-sloping original supply curve (S). An ad valorem tax shifts the supply curve leftward to a steeper position (S₁), creating a new equilibrium at a higher price (P₁) and lower quantity (Q₁) compared to the original price (P) and quantity (Q).

Features:

• The total tax revenue is represented by the area between the new and original supply curves, from the new equilibrium down to a point on the original supply curve at a lower price (P₂).
• This total tax area breaks down into the consumer's share (the portion above the original price, reflecting the price increase they pay) and the producer's share (the portion below the original price, indicating the reduced revenue producers receive after tax).

Factors influencing tax incidence

The division of the tax burden hinges on PED:

• Inelastic demand - When demand is price inelastic (e.g., for essential or addictive goods like tobacco), consumers bear most of the tax through higher prices, as they continue buying despite the increase.
• Elastic demand - If demand is price elastic (e.g., for luxury items), producers absorb more of the tax to avoid losing sales, limiting the price rise passed on to consumers.

Advantages and disadvantages of indirect taxes on demerit goods

Indirect taxes on demerit goods—products with significant negative externalities—offer benefits but also present challenges for governments, firms, and economies.

Advantages of indirect taxes on demerit goods

• Internalising externalities - By embedding external costs in the price, these taxes can discourage consumption and production, mitigating harms like environmental damage or health issues.
• Revenue for offsetting measures - Even if demand remains steady, the funds generated can support initiatives to address the externalities, such as anti-smoking campaigns financed by cigarette taxes.

Disadvantages of indirect taxes on demerit goods

• Valuation challenges - Accurately quantifying the monetary cost of negative externalities is complex, potentially leading to taxes that are too high or low.
• Limited impact on inelastic goods - For products with price-inelastic demand, like alcohol, the tax may not reduce consumption significantly, failing to curb the externalities.
• Reduced competitiveness - Higher production costs can make domestic goods less attractive internationally, harming export performance.
• Business relocation risks - Firms might move operations overseas to escape the taxes, resulting in lost economic contributions such as jobs and tax revenue.
• Misallocation of revenue - There is no guarantee that tax proceeds will be used to tackle the specific externalities, potentially diverting funds elsewhere.