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!

1. Government Intervention – Indirect
Taxes

2. Government
Intervention in Markets
Indirect Taxes

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. 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. 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. 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. 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. 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

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