Using Indirect Taxes to Correct Market Failure
- An indirect tax is an expenditure tax that is paid when goods and services are purchased
- Indirect taxes are levied by the government to solve market failure and/or to raise government revenue
- Government revenue is used to fund government provision of goods/services e.g education
- Indirect taxes are levied by the government on producers, increasing the cost of production for firms
- Costs can be transferred on to consumers via higher prices
- Higher prices reduce quantity demanded (QD) and discourage the consumption of specific goods or services, for example demerit goods or products that generate negative externalities
Diagram: Impact of an Indirect Tax
An indirect tax is split between the consumer (A) and the producer (B)
Diagram analysis
- The initial equilibrium is at P1Q1
- The government places a specific tax on a demerit good
- The supply curve shifts upward from S1→S2 by the amount of the tax
- The new equilibrium is at P2Q2
- The price the consumer pays has increased from P1 to P2
- The price the producer receives has decreased from P1 to P3
- The government receives tax revenue = (P2 - P3) x Q2
- Producers and consumers each pay a share or (incidence) of the tax
- The consumer incidence of the tax is equal to area A: (P2 - P1) x Q2
- The producer incidence of the tax is equal to area B: (P1 - P3) x Q2
- The final price is higher and QD is lower, resulting in a deadweight loss to society
Evaluating the use of Indirect Taxes
Advantages |
Disadvantages |
|
|
Exam Tip
The size of the tax incidence on the consumer and producer depends on the elasticities of the demand and supply curves. If evaluating the impact of an indirect tax, consider the PED and PES.
If demand is price-inelastic or supply is price-elastic, the tax burden will be greater for the consumer.
If demand is price-elastic or supply is price-inelastic, the tax burden will be greater for the producer.