Indirect taxes

Indirect taxes are taxes on spending, while direct taxes are taxes on income. Indirect taxes include value added tax, sales tax and import duties. Direct taxes include personal income tax, company taxes on profits, and capital gains taxes.

Tax incidence

The incidence of a tax refers to who bears the burden of the tax. Tax burdens can either fall on consumers, or producers, or both.

While we tend to think of indirect taxes in terms of the impact on consumers, producers may also bear some of the tax if the amount consumers pay in tax does not cover the tax demand from the government.

How much of the incidence of an indirect tax falls on the consumer is determined by how much the price rises.

Tax incidence

The vertical distance between S and S1 is the tax per unit, and the incidence on the consumer is the distance P to P1 times the new quantity sold - 0 to Q1. Given that the government requires the whole tax, the producer must pay the rest out of its revenue. So, if the price does not rise at all (when PED is infinite), the whole incidence falls on the producer (in this case any increase in price would result in a drop in sales to zero).

The relative burden between producer and consumer is, therefore, determined by the price elasticity of demand.

Tax incidence

Significance of incidence

There is considerable interest in tax incidence especially in the area of public policy. The use of taxation to reduce 'negative' activity dates back to English economist, Arthur Pigou’s work on welfare economics. Pigou argued that the effect of negative externalities could be offset by taxes (which were later to be referred to as Pigouvian taxes.)

The effective introduction of new taxes, such as environmental taxes, requires that policy-makers understand how the tax is likely to change behaviour.

For example, a great deal of resistance to carbon taxes comes from the fact that the incidence is often felt most by the consumer. This means that carbon taxes are often regressive in nature (where the burden falls largely on the low paid).

This knowledge can inform decisions about how best to mitigate against such taxes, and adjust policy - such as using subsidies to encourage carbon reduction, and rolling out new taxes slowly so that consumers can adjust their expectations more gradually.

PED formula

How is PED calculated?

PED formula

How is equilibrium determined?

Elasticity of supply

What determines supply elasticity?

Supply elasticity

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