Indirect Taxes

Government Intervention: In the world today most markets are not free markets, but are
considered mixed markets.

Mixed Market: Free Market + Government Intervention

How Government Intervenes (Government Intervention into Free Markets):

1. Taxes
2. Subsidies
3. Price Controls

Indirect Tax: Taxes placed on goods and services.

- Called indirect taxes because the consumer indirectly pays them to the government.
- Consumer - Seller - Government

Indirect tax can be broken up into two different types of taxes:

● Specific Tax: The amount of tax is an absolute value per unit.
● Ad Valorem Tax: Percentage of the sale.

Specific Tax: Specific Tax - Flat Tax

- Specific amount charged per unit of product sold.
Ad Valorem Tax: Ad Valorem - (VAT)
 - Percentage tax on a good or service.
- The higher the price, the overall amount of tax collected increases.

Effect of Taxes:
- Consequences to the stakeholder:
1. Consumers
2. Producers
3. Government

Consequences:

1. Increase Prices: Determinant of Supply

2. Reduce the output: Smaller quantities offered for sale.
3. Market size gets smaller because of reduced output.
4. Consumer Suffer: Pay higher price and receive less of the product.
5. Producer Suffer: Increase cost, produce less and profits become smaller.
6. Government: Increase the revenue for the government.
 Incidence of Taxation

Excise Tax: Either a specific tax or an ad valorem tax on a particular good or service.
- Specific Tax: A tax of a specific amount to be paid on every unit of a product sold.
- Ad Valorem Tax: A tax based on a particular percentage of the sales price of a
product.

Incidence of Taxation: Examines the amount a specific tax has on the consumer, producer,
and government.

Three Cases:
1. PED similar to PES
2. PED > PES
3. PED < PES

Consumer Surplus: The price a consumer is willing and able to pay minus the actual amount
they paid. (Above the price equilibrium below the demand curve)

Producer Surplus: The price a producer is willing to supply a good to the market minus the
price they actually receive. Below price equilibrium and above the supply curve.

Total Welfare Loss (TWL): The consumer and producer surplus lost due to disequilibrium
existing in the market.
- The market is said to not be allocatively efficient.

Tax Incidence: PED is similar to PES

Government Intervention - Specific Tax Creates Disequilibrium in The Market

With a specific tax added:

1. Price increases R0 - R1

2. Quantity decreases

3. Consumer Surplus decreases

4. Producer Surplus decreases

5. Total Welfare Loss (Shaded Triangle).

6. Consumers & Producers equally share the incidence of the tax.

7. Government Revenue = Consumers & Producers share.

● When PED is similar to PES the Consumer and Producer burden of the tax is shared
evenly
● When a tax is applied, the market is allocatively inefficient creating a total welfare
loss.
Tax Incidence: PED > PES

With a specific tax added to a good with elastic demand:

1. Consumer Burden of Tax

a. (P1 - P) × Q
2. Producer Burden of Tax
a. (P - X) × Q
3. Consumer Burden of Tax
a. (P1 - X) × Q

PED > PES

%↑P < %↓Q

Consumer < Producers

CB < PB
Tax Incidence: PED < PES

With a specific tax added to a good with elastic demand: The incidence of taxation for
consumers is greater than the incidence for producers.

● The more elastic the PED the greater the Total Welfare Loss (TWL).
● The larger the PED the greater the ↓ Qd
○ Combinations of goods and services produced is much less than is
soresulting in a larger total welfare loss.
 Incidence of Subsidy

PED < PES

% P (Decrease) > %Qd (Increases)

Consumer Producer

CG > PG (When PED < PES)

No Subsidy Subsidy

Pc P Pc

Pp P Pp

CS a+b a+b+d+e+f

PS d +h b+c+d+h

Consumer Expenditure P ×Q Pc × Q1

Producer Revenue P ×Q Pp × Q1

Total Welfare Loss 0 g

Consumer Gain 0 d+e+f

Producer Gain 0 b+c

New Welfare Created 0 c = (PS)

e + f = (CS)

PED > PES

% P (Decrease) < %Qd (Increases)

Consumer Producer

CG > PG (When PED > PES)

 Price Ceiling

Government imposed maximum (A Legal Maximum)

- Price imposed on a good
- Below the equilibrium price.

Why does the price ceiling need to be below the equilibrium price to be effective?
- If it is set below the equilibrium price the price mechanism is not able to reallocate the
resources.

No Intervention Price Ceiling

CS a+b+c a+b+d

PS d+e+f F

TWL 0 c+e

P Consumer Pe P Ceiling

P Black Market 0 PBM

Consequences of Price Ceilings:

1. Not allocatively efficient

a. TWL
2. Shortages
 3. Non Price Rationing
a. Coupons
b. First come first serve
4. Parallel Markets
a. Black Markets

Effect on Consumers (Depends):

- Those that are able to get the product benefit from an increase in their consumer
surplus.

- Those that don’t do not benefit and lose

Effect on Producers:
- Worse off decrease in producer surplus and decrease in price received.

Society:
- Worse off

Price Floor

Price floor is the government imposed legal minimum price.

Price is set above the equilibrium price:

● Goal: Not allow the price mechanism to reallocate resources.
● If set below the minimum price will be the Market Equilibrium

Qs ≠ Qd
Qs > Qs
Which results in a surplus.
 No Interference Price Floor Government
Purchaser

Pc P Pfloor Pfloor

Pp P Pfloor Pfloor

CS a+b+c a a

PS d+e b+d b+c+d+e+f

TWL 0 c+e c+f+g+h+i

Government 0 0 Pfloor × (Qs - Qd)

Purchase Cost

Welfare Gain 0 0 d

Producer Revenue P × Qe Pfloor × Qd Pfloor × Qs

Consumer P × Qe Pfloor × Qd Pfloor × Qd

Expenditure
Government purchase excess supply → Consumer
● Non-Price Determinant of Demand → Size of Market → ↑ Demand

Consumers: Worse of → ↓ Cs (a+b+c → a)

Producer: Government Purchase

● Better off
○ ↑ Ps (e-f → b+c+d+e+f)
○ ↑ Tr (P × Qe → Pfloor × Qs)

Government:
● What to do with the cashews?
● Worse → Cost for Government
● Opportunity Cost: Money could have been used for infrastructure.

Linear Demand Function:

Qd = a - b(p)

Linear Supply Function:

Qs = -c + d(p)
Tax:
Qs = -c + d(p-tax)

Subsidy:
Qs = -c + d(p+subsidy)