The types of indirect taxes

Indirect taxes are charges applied to the sale of goods or services, rather than directly on individuals or organisations. These differ from direct taxes, such as those on income or property, which are paid straight to the government by the taxpayer.

Main types of indirect taxes

• Specific taxes - These involve a fixed charge per unit of the good, regardless of its price. For instance, a set fee might be added to each litre of petrol, applying the same amount whether the petrol is cheap or expensive.
• Ad valorem taxes - These are calculated as a percentage of the good's price. For example, a 15% tax on a £20 item would add £3, while the same tax on a £100 item would add £15.

Multiple indirect taxes can apply to a single product, such as combining a specific excise duty with an ad valorem value-added tax (VAT) on items like alcoholic drinks.

How indirect taxes affect supply

Indirect taxes raise production costs for firms, leading to changes in the supply curve. This shift reduces the quantity supplied at each price level.

Effects on the supply curve

• Specific taxes - These cause a parallel leftward shift in the supply curve, as the fixed tax amount increases costs equally across all price levels.
• Ad valorem taxes - These result in a non-parallel leftward shift, with a greater impact on higher-priced goods because the tax takes a larger absolute amount from more expensive items.

The purpose of taxing goods with negative externalities

Governments often apply indirect taxes to goods or services that generate negative externalities, which are harmful effects on third parties not involved in the transaction. The aim is to internalise these externalities by making producers or consumers pay for the wider social costs.

Goods commonly targeted by such taxes

• Fossil fuels, due to their contribution to pollution and climate change.
• Sugary drinks, linked to health issues like obesity.
• Tobacco products, associated with health risks and healthcare burdens.

Additional roles of these taxes

• Generating revenue - Funds raised can support initiatives to counteract the externalities, such as using taxes from high-sugar products to finance health education programmes.
• Encouraging behavioural change - Taxes like those on waste disposal promote positive actions, such as recycling, while deterring harmful ones, like excessive pollution.
• Reflecting social costs - Environmental taxes ensure that the full impact of damage, including pollution, is factored into prices.

However, unintended effects can arise, such as increased illegal activities to evade taxes, like unauthorised waste dumping.

How the burden of tax is shared

The burden of an indirect tax is divided between consumers and producers, depending on how much the price rises and how much producers absorb in reduced revenue.

Sharing the tax burden

• Consumer share - This equals the increase in the price paid after the tax is imposed.
• Producer share - This is the difference between the price producers receive post-tax and the original price before tax.

Role of price elasticity of demand

• Inelastic demand - When demand is price inelastic, consumers bear most of the tax burden because they continue buying despite higher prices.
• Elastic demand - When demand is price elastic, producers shoulder more of the burden as they may need to lower their prices to maintain sales volumes.

Advantages and disadvantages of taxing goods with negative externalities

Taxing products that cause negative externalities has both benefits and drawbacks, influencing economic behaviour, government revenue, and international trade.

Advantages of these taxes

• Internalising costs - Incorporates the social costs of externalities into the product's price, making users accountable.
• Reducing consumption - Can lower demand and production of harmful goods, leading to fewer negative effects.
• Revenue for solutions - Generates funds that governments can use to mitigate the externalities, such as supporting addiction treatment from tobacco taxes.
• Promoting better choices - Encourages shifts away from damaging behaviours, like reducing reliance on polluting fuels.

Disadvantages of these taxes

• Challenges in valuation - It is hard to accurately quantify the monetary cost of externalities for setting appropriate tax levels.
• Limited impact on inelastic goods - For products with price-inelastic demand, taxes may not significantly reduce consumption.
• Harm to competitiveness - Higher taxes can make domestic firms less competitive internationally, potentially leading to lost market share.
• Risk of relocation - Businesses might move operations abroad to avoid taxes, resulting in reduced domestic employment and government revenue.
• Misuse of funds - Tax income may not always be directed towards addressing the externalities, limiting the policy's effectiveness.