Revision notes on indirect taxes

1. 1. Indirect Taxation
 An indirect tax is imposed on producers (suppliers) by the government. Examples include duties on
cigarettes, alcohol and fuel and also VAT
 VAT is a tax placed on the expenditure / a tax set as a percentage of the price of a good)
 A tax increases the costs of production causing an inward shift in the supply curve
 The vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit
 With an indirect tax, the supplier may be able to pass on some or all of this tax onto the consumer through a
higher price
 This is known as shifting the burden of the tax and the ability of businesses to do this depends on the price
elasticity of demand and supply
A Tax When Demand is Price Elastic A Tax when Demand is Price Inelastic
Price Price
S + Tax
S1 S + Tax
S1
P2 P2
P1
D1
P1
D1
Q2 Q1 Quantity Q2 Q1 Quantity
 In the left hand diagram, demand is elastic so the producer must absorb most of the tax and accept a lower
profit margin on each unit. When demand is elastic, the effect of a tax is to raise the price – but we see a
bigger fall in quantity. Output has fallen from Q to Q1.
 In the right hand diagram demand for the product is inelastic and therefore the producer is able to pass on
most of the tax to the consumer by raising price without losing much in the way of sales.
The table below shows the demand and supply schedules for a good
Price (£) Quantity Demanded Quantity Supplied Quantity supplied
(Pre-tax) (Post-tax)
10 20 1280 600
9 60 1000 400
8 150 850 150
7 260 600 50
6 400 400
5 600 150
4 900 50

2. 1 What is the initial equilibrium price and quantity? Price = £6
Quantity = 400
2 The government imposes a tax of £3 per unit. The new supply schedule is shown in the right hand column of the
table – less is now supplied at each and every market price
3 Find the new equilibrium price after the tax has been imposed New price =£8
4 Calculate the total tax revenue going to the government Tax revenue = £450
5 How have consumers been affected by this tax?
There has been a fall in quantity traded and a rise in the price paid by consumers – this leads to a fall in
economic welfare as measured by consumer surplus
Who pays the tax? The burden of taxation
When demand is inelastic, the producer is able to pass on most or perhaps all of an indirect
tax to the consumer by raising the market price. Conversely when demand is price elastic,
the producer cannot pass on much of the tax to the consumer, they must absorb the majority
majority of the tax themselves
A Tax When Demand is Price Elastic A Tax when Demand is Price Inelastic
Price Price
S + Tax S + Tax
S1
S1
P2
P2
P1
P3 D1 P1
P3
D1
Q2 Q1 Quantity Q2 Q1 Quantity
The burden of an indirect The burden of an indirect
tax paid by the consumer tax paid by the producer
The Government would rather place indirect taxes on commodities where demand is inelastic because the tax
causes only a small fall in the quantity consumed and as a result the total revenue from taxes will be greater. An
example of this is the high level of duty on cigarettes and petrol.
 Specific taxes: A specific tax is where the tax per unit is a fixed amount – for example the duty on a pint of
beer or the tax per packet of twenty cigarettes. Another example is air passenger duty
 Ad valorem taxes: Where the tax is a percentage of the cost of supply – e.g. value added tax currently
levied at the standard rate of 15%. In the diagram below, an ad valorem tax has been imposed on producers.
The equilibrium price rises from P1 to P2 whilst quantity falls from Q1 to Q2.

3. Price
An ad valorem tax causes Supply + Ad
a pivotal shift in the valorem tax
producer’s supply curve
S1
P1
P2
Demand
Q1 Q2 Quantity
 Note that 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 Intervention in the Market
supplied for a cost of £50 will now cost £58.75 when
The Hungarian government has
VAT of 17.5% is applied whereas a different good that launched a new bill to impose a tax
costs £400 to supply will now cost £470 when the same of between five percent and 20
rate of VAT is applied percent on food and drink products
which contain excessive levels of salt
 The absolute amount of the tax will go up as the market or sugar. This tax is already known
price increases as the "chocolate tax" and the
 Tobacco is an example of a product on which both authorities hope it will make the
nation healthier.
specific and ad valorem taxes are applied.
Indirect taxes and black markets
One of the disadvantages of indirect taxes, particularly the so-called ‘sin taxes’ levied on tobacco and alcohol, is that they can give
rise to a black market in the goods in order to avoid the tax, and this is a source of government failure. According to estim ates by
HM Revenue & Customs, up to 54 per cent of hand rolling tobacco and 17 per cent of cigarettes consumed in the UK are
smuggled, costing the Treasury £3 billion in lost tax revenue in 2007-08 alone. With the current fiscal deficit, the British Treasury
needs that revenue!
Source: Tutor2u Economics Blog, Penny Brooks, March 2010
Russia increases taxes on beer
Concerned by Russia's high rate of alcohol consumption, the government has raised the tax on beer by 200% and introduced
tougher legislation. New laws prohibit the sale of beverages with an alcohol content of more than 5% between 11pm and 8am. Be er
sales are also banned from sidewalk kiosks and advertising of alcoholic products on television, radio and outdoor media will be
prohibited from summer 2012. Mainly because of higher taxes, beer prices in Russia have jumped by 30% over the past 18 months
and higher prices have caused average beer consumption to fall to 66 liters per person last year from 80 litres in 2008.
Source: Adapted from news reports, July 2011

4. Case Study: Is the Tax on Beer Costing Jobs?
About £1 from every pint of beer sold in the UK goes straight to the government and that is just from VAT and excise
duty on their own.
Higher taxes have been one factor bringing down consumption levels. There has been a 13 per cent decline in alcohol
consumption per head in Britain since 2004. The percentage of men aged 16-24 who drank more than 21 units per
week has fallen from 32 per cent to 21 per cent from 2005 to 2010
The UK beer industry including the British Beer and Pub Association is lobbying the government for a reversal of the
planned increases in beer duties.
The UK alcohol duty escalator, which increases tax on beer (and other alcoholic drinks) by 2 per cent above the rate
of inflation, has been in place since 2008 and will mean a 6-7% rise in average beer prices this year. A bitter blow for
drinkers!
Since 1 October 2011, all beers with alcohol content of 2.8% abv and below are being taxed less, to the equivalent of
around 35p on every pint when compared with a typical 4.2% cent beer.
Beer duty – key facts
950,000 British jobs depend on the UK beer and pub sector
There are now 900 breweries in the UK – a vital part of Britain’s manufacturing mix
£13 billion is paid in wages in the sector
Brewing and pubs are worth £19.4 billion to the UK economy (Gross Value Added)
The beer and pub sector contributes over £11 billion in tax revenues
Questions:
1. Why does the government impose an excise duty on beer?
2. Is a tax beer fair?
3. Build the case for a higher duty on beer as a way of cutting alcoholism
4. Identify and discuss some alternative policies that might be introduced if a government wishes to curb binge
drinking