In the following video we are going to take a look at taxation, how it impacts the market,
and tax incidence.
We will need to establish a basic understanding of tax and will examine taxation further in
the following units when discussing government macroeconomic policy.
Before we define any key terms, it is important to understand why government imposes taxes.
Taxes serve to discourage consumption and also to raise revenue for the government.
This tax revenue is used to fund government spending.
We will go into further detail regarding taxation and government spending when we explore fiscal
policy in a later unit.
A direct tax, is levied on income, wealth and profit.
Direct taxes include income tax, capital gains tax and corporation tax.
It is taken directly from the individual or entity earning income.
An indirect tax, is levied on expenditure.
While it is collected from sellers, sellers will often pass some of this tax onto the
buyers of their products.
How much is passed on to consumers is called the consumer incidence, and the portion that
is paid by the producer is called the producer incidence.
We’ll examine this shortly.
There are two types of indirect taxes we are going to analyse and diagram.
The first is a specific, or per-unit tax, which is a fixed amount of tax charged to
the seller for each good or service sold.
The second is an ad valorem tax, or value added tax, which is a tax that is based upon
the value of a transaction.
It is often levied as a percentage of the good’s value.
We’ll take a look at the impact of a specific tax for products that have elastic and inelastic
demand.
With this market in equilibrium, we establish our starting point for analysis.
Suppose the government introduces a specific tax, increasing the costs of production for
firms.
As they are paying the same tax for each unit sold, the new supply curve is parallel to
the initial supply curve.
The distance between the two supply curves is the value of our tax as indicated by the
green arrows.
After the tax has been imposed, we can see the supply curve shifts leftward.
The new, higher market price is Pc and the new, lower market quantity is Q1.
Therefore the impact of a specific tax on a product with elastic demand is to reduce
equilibrium quantity and raise price.
However, it is important to note that the impact on price and quantity largely depends
on the elasticity of demand for the product as we’ll see in the next slide.
A product with inelastic demand would see its price rise sharply, but with little corresponding
reduction in quantity.
This is why taxes are argued to be ineffective at reducing smoking.
Cigarettes are addictive and rising prices are unlikely to deter smokers.
The tax can be a great source of revenue for the government and many would argue that there
are more effective ways at reducing smoking than increasing taxes.
That’s a topic for another video, for now let’s focus on the diagram.
If the demand curve were perfectly inelastic, the price of the good would rise by the full
value of the tax but there would be no change in equilibrium quantity.
This is the part where it often gets tricky for students, so I’ve tried to break it
down into manageable chunks.
If you have difficulty, slow down the video, pause it and review the parts where you are
unclear.
We’re going to see the incidence, or burden, of tax.
We’ve already established that the price consumers pay is Pc.
You’ll note that the difference between the supply curves is the value of the tax,
but the price increase from equilibrium to Pc is not equal to the entire amount of the
tax.
At Pc, there are Q1 units produced.
At output of Q1, the per unit tax is represented by the distance between the supply curves.
Therefore after the tax is deducted from the price paid by the consumer, we have the price
received by the seller, Ps.
The value of the tax is the difference between Pc and Ps.
Now we are able to determine the burden of taxation taken on by consumers and producers.
The portion that is taken up by producers is the area below the initial equilibrium
price and above the price received by sellers.
It is bordered by Q1.
The burden on consumers is equal to the amount they are paying above the initial equilibrium
price times the quantity sold of Q1, represented on the graph in green.
The total tax revenue received by the government is the area including both the consumer and
producer burden.
It can be calculated by multiplying Q1 * (Pc-Ps).
The consumer surplus is represented by the area
above the price paid by consumers and below the demand curve.
It has clearly been reduced by the imposition of the tax.
The producer surplus is represented by the area above the supply curve and below the
price that sellers receive.
It has also clearly been reduced by the tax.
The green and red portion represent the revenue taken by the government, but we still have
an unaccounted for region, represented by the blue triangle on the right.
This area represents our deadweight loss.
If the market was functioning without any tax, it would clear at equilibrium.
Consumers and producers still enjoy some surplus, and the government collects revenue.
The blue triangle represents a reduction in the overall welfare of society, since no party
can enjoy the benefit, resulting in deadweight loss.
The value of each of these depends greatly on the elasticity of demand for the product
- as we will see in the next example.
I’d encourage you to pause this video and replicate this diagram in your notes.
Once you’ve done that, label the new consumer surplus, producer surplus and deadweight loss.
You should be able to draw and understand this diagram for all elasticity ranges, from
perfectly inelastic demand to perfectly elastic demand.
Alright, I hope you’re still with me and are feeling more comfortable with the concept
of tax, its impact and incidence.
This is a tough topic and one that many AS students struggle with.
I hope I’ve been able to shed some light on the subject and help you understand it
better.
Stick with me as we continue to work through the rest of the CIE syllabus and you should
start to feel more confident with these concepts as you see them throughout the course.
As always, feel free to contact me at enhancetuition@gmail.com or tweet me @EnhanceTuition.
Leave a comment below if there’s anything in particular I can help you with.