An indirect tax is a tax on a good or service, e.g. Value Added Tax (VAT). It may be levied as a percentage of the price of the product (ad valorem tax), e.g. VAT. It may also be levied as a fixed amount per unit of the product (specific tax), e.g. fuel tax. An indirect tax adds to the cost of production and shifts the supply curve leftwards. For a specific tax, the amount of tax per unit is the same no matter the market price; there will be a parallel shift in the supply curve. The amount of tax increases as the market price increases for ad valorem tax and the supply curve pivots (Figure 1 below).
Figure 1: Specific tax and ad valorem tax
Consequences of the imposition of indirect tax
An indirect tax is usually imposed on demerit goods, such as alcohol and cigarettes, to reduce the quantity consumed. The imposition of indirect tax reduces the supply and the equilibrium quantity. The government can also use indirect tax to raise revenue, especially if the product has inelastic demand. The government will be able to raise revenue as long as people buy the product. Indirect tax raises the price of a product and the quantity demanded of a product with inelastic demand will fall by a smaller percentage, allowing the government to generate a considerable amount of tax revenue. Government revenue from a product with elastic demand will be lesser since a rise in price will lead to a greater percentage fall in quantity demanded.
Indirect tax tends to favour high-income earners more than low-income earners because it is regressive in nature. A regressive tax is one in which the tax rate falls as income increases. The absolute amount of tax paid by everyone is the same but it forms a bigger percentage of the income of a low-income earner and a smaller percentage of the income of a high-income earner. The imposition of indirect tax can result in welfare loss to the society, i.e. the quantity supplied and consumed falls below the most desirable quantity for the society. This is known as a deadweight loss. It is represented by the area of triangle ABC in Figure 2 below. The new quantity Q2 is less than what it is without indirect tax (Q1).
Figure 2: Deadweight loss from indirect taxation
Tax incidence and price elasticity of demand
The imposition of indirect tax shifts the supply curve to the left and increases the price. But the price consumers pay does not rise by the total amount of tax for a downward-sloping demand curve. The burden of tax is shared between the consumers and producers. In Figure 3 below, the amount of tax per unit is P2-P3 but the price is only increased from P1 to P2. It means that the amount of tax per unit borne by the producers is from P1 to P3. The total tax revenue paid to the government is shown by the whole rectangle P2P3EG. The consumers’ tax burden is represented by the area of rectangle P2P1EF while the producers bear the area of rectangle P1P3FG. The price paid by the consumer is P2 while the price received by the producer is P3. Take note that the elasticity of the demand curve determines who bears the greater part of the tax burden. In Figure 3, the consumers’ share is greater because the demand curve is relatively inelastic. In other words, the producers can shift the greater part of the burden to the consumers through price increases because the consumers will only cut their demand by a smaller percentage (less price responsive).
Figure 3: Tax incidence for relatively inelastic demand
If demand is relatively elastic, the producers’ share of the tax burden will be greater than the consumers’ share because any price increase will lead to a greater percentage fall in quantity demand. This will lead to a revenue fall for the producers. Therefore, the producers would bear the greater part of the burden. Only a smaller part of the tax will be added to the price since consumers are price responsive (see Figure 4 below).
Figure 4: Tax incidence for relatively elastic demand
The producers pass all the tax burden to the consumers if demand is perfectly inelastic by adding the whole amount of tax per unit to the price. This is because the quantity demanded remains the same regardless of the price increase. In Figure 5 below, the price paid by the consumers increased by the full amount of tax per unit from P1 to P2. The whole tax burden is shown by the area of rectangle P2P1KL falls on the consumers.
Figure 5: Tax incidence for perfectly inelastic demand
If demand is perfectly elastic, the producers bear all the tax burden because a slight increase in price will bring the quantity demanded to zero. The price consumers pay P1 is the same even after the imposition of tax on the good (see Figure 6 below). But the price received by the producers is P2 and they are responsible for the whole tax represented by rectangle P1P2MN.
Figure 6: Tax incidence for perfectly elastic demand
Tax incidence and price elasticity of supply
The tax revenue is larger the more inelastic the demand and supply are. If supply is more elastic than demand, the buyers bear most of the tax burden (Figure 3 above). But if demand is more elastic than supply, producers bear most of the cost of the tax (Figure 4 above).
Figure 7: Tax incidence for perfectly elastic supply
If supply is perfectly elastic, the consumers bear the entire burden. In Figure 7 above, the consumers pay P2 due to taxation and the total tax burden represented by the area of rectangle P2P1QR is borne by only the consumers.
Figure 8: Tax incidence for perfectly inelastic supply
But if supply is perfectly inelastic as in Figure 8 above, the producers bear the entire tax burden shown by the area of rectangle P1P2ST. The consumers pay P1 but the producers receive P2 after the tax.