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Tutor2u - Government Intervention – Indirect Taxes


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Students need to be able to understand the aims and effects of indirect taxes as a form of government intervention in different markets and industries. Price elasticity of demand affects whether a producer can pass on an indirect tax to the consumer. Most questions on taxation require good analysis diagrams and then evaluation of the likely effects. Always remember to consider alternatives and challenge whether a tax is effective in meeting set aims. A change in taxes can have unintended consequences!

Published in: Economy & Finance
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Tutor2u - Government Intervention – Indirect Taxes

  1. 1. Government Intervention – Indirect Taxes
  2. 2. Government Intervention in Markets Indirect Taxes
  3. 3. Indirect Taxes in Markets • An indirect tax is a tax imposed by the government that increases the supply costs faced by producers. • The amount of the tax is always shown by the vertical distance between the two supply curves. • Because of the tax, less can be supplied at each price level. • The result is an increase in the market price and a contraction in demand to a new equilibrium output. 1. A specific tax is a set tax per unit e.g. a £5 tax per unit sold. 2. An ad valorem tax is a percentage tax e.g. 20% on the unit price. • The main UK indirect tax is VAT - generating £110bn annual tax • Fuel duties generate £27bn and tobacco taxes £10bn each year • Taxes such as air passenger duty bring in £3bn of tax each year Exam Tip: Use clear analysis diagrams to show the impact of an indirect tax
  4. 4. Examples of Indirect Taxes in the UK Economy VAT Landfill Tax Fuel Duties Alcohol Duties Tobacco Duties Air Passenger Duty Standard rate = 20% £80 per tonne for waste Taxed at 58p per litre Bands based on distance£3.76 per pack + 17% VATBeer tax = 41.5p per pint
  5. 5. Indirect Tax When PED = 0 and PES = infinity Price Qty P2 Demand P1 Q1 S1 S1 + tax Total Tax Revenue (paid by the consumer) Price Qty Demand S1 S1 + tax Q1Q2 P2 P1 Total Tax paid by the consumer Perfectly Inelastic Demand All of the tax is paid by the consumer Perfectly Elastic Supply All of the tax is paid by the consumer Tax Per Unit
  6. 6. Indirect Taxes with Different Coefficient of PED If the co-efficient of price elasticity of demand >1, then most of the burden of an indirect tax will be absorbed by the supplier Price Qty P2 D Q2 S1 S1 + tax Q1 P1 P3 Paid by consumer Paid by supplier If the co-efficient of price elasticity of demand <1, most of an indirect tax can be passed on to the final consumer Price Qty P2 Demand P1 Q2 S1 S1 + tax Q1 P3 Paid by consumer Paid by supplier Tax Per Unit
  7. 7. Ad Valorem (Indirect) Taxes Value added tax (the standard rate in the UK is 20%) is an example of an ad valorem tax. Quantity P2 Demand P1 Q2 S1 S1 + tax Q1 Price • The effect of an ad valorem tax is to cause a pivotal shift in the supply curve • This is because the tax is a percentage of the unit cost of supplying the product. • So a good that could be supplied for a cost of £50 will now cost £60 when VAT of 20% is applied whereas a different good that costs £400 to supply will now cost £470 when the same rate of VAT is applied • The absolute amount of the tax will go up as the market price increases Tax Per Unit
  8. 8. Evaluation Arguments when Assessing Indirect Taxes • Does an indirect tax achieve the specified aims? • Are there unintended consequences of introducing / changing a tax? Effectiveness of a tax and unintended consequences • Does an indirect tax generate substantial tax revenues? • How is the tax revenue used – perhaps for particular projects? How much tax revenue is raised? How is it used? • Might there be a possible loss of jobs and/or capital investment? • Will an indirect tax negatively affect competitiveness and trade? What is the impact on businesses / competitiveness? • Is the tax regarded as equitable / fair? • Who are the main winners and losers? • Does a tax have a regressive effect on lower income groups? Consequences for equity / the distribution of income
  9. 9. Get help from fellow students, teachers and tutor2u on Twitter: @tutor2u_econ
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