Cookie Consent by TermsFeed
pexels karolina grabowska 4386372 scaled

11. Taxes

This article will go through the different types of taxes and will explain where the incidence of taxes lies. Furthermore, the article will outline how the price elasticity of demand and supply can affect the incidence of tax.

Welcome to Simply Economics. This article is the thirteenth in a series to explain economics to those who want to broaden their scope of the subject. Click here to find out more about the series.

WHAT IS A TAX?

A tax is a charge imposed by the government on products and capital. The reason why governments impose taxes is to raise funds for government spending. Governments spend money to supply merit goods that the private sector will not.

TYPES OF TAXES

There are 2 types of taxes:

  • Direct tax – A direct is imposed on a certain person or organisation. They are paid on the income of the individual or company. An example of this is co-operation tax where a percentage of a company’s profits are taxed by the government.
  • Indirect tax – An indirect tax is imposed on the consumption of goods and services. There are two main types of indirect taxes:
    • Specific
    • Ad valorem

AD VALOREM TAXES

An ad valorem tax is levied as a percentage of the goods. An example of an ad valorem tax is VAT, which is 20% in the UK. The quantity of tax is dependent upon the value of the good being bought.

The ad valorem tax causes a pivoted inward shift in supply and not a direct inward shift as shown below. This is because the size of ad valorem tax varies with output i.e. as output increases so does the tax and as output decreases so does ad valorem tax.

Taxes, tax, incidence of tax

SPECIFIC TAX

A specific tax is added to the price of a good and therefore is not variable with output. An example of this is an excise duty which is usually applied on alcohol and petrol.

The specific tax causes a normal inward shift in the supply curve of a good as shown below.

Taxes, tax, incidence of tax

INCIDENCE OF TAX

Tax is usually paid by both consumers and producers. However, the quantity of the tax that is paid by consumers and producers is dependent upon the price elasticity of demand and supply of the good.

Figure 1 shows how the incidence of tax is shown by a demand and supply diagram. The orange area, DYZPe is the consumer tax i.e. the amount of tax consumers must pay at the equilibrium level. The green area is the amount of tax the producers must pay to supply the good at that price.

Taxes, tax, incidence of tax
Figure 1.

THE EFFECT OF PRICE ELASTICITY OF DEMAND AND SUPPLY ON THE INCIDENCE OF TAX

The amount of tax that is paid by the consumer and the producer is dependent upon the price elasticity of supply and demand. For example, if demand is inelastic and supply is elastic to the price of the good then most of the tax will fall upon the consumer as shown below in figure 2

Taxes, tax, incidence of tax
Figure 2.

As shown by figure 2 most of the tax burden is on the consumer. This is because producers are able to place most of the tax onto the consumer through higher prices because demand is inelastic which mean that the increase in revenue that the producer will gain through higher prices will outweigh the loss in revenue due to a fall in demand. (Click here to learn more about price elasticities).

However, if a good has elastic demand and inelastic supply then most of the tax will be placed on the producer, as shown below by figure 3.

Taxes, tax, incidence of tax
Figure 3.

As shown by figure 3 most of the tax burden is on the producer. This is because producers are not able to raise prices too much because demand is elastic and therefore if there is an increase in price then a loss in revenue due to a fall in demand will be much greater than the gain in revenue due to higher prices. Hence, most of the tax must be paid by the producer.

In conclusion, there are 2 types of tax; direct and indirect taxes. Indirect taxes are split into two categories; ad valorem and specific. Ad valorem tax is taken as a percentage of the good sold and specific tax is taken at a constant rate of the product. Lastly, the incidence of tax is dependent on the elasticity of demand and supply of the good.

Feel free to ask any questions and sign up below for the latest updates. Click here for more articles. For more articles in the Economics for Beginners series, click here.

what is quantitative easing?

What is Quantitative Easing (QE)

This article will explain the key concepts of Quantitative Easing. It will explain how Quantitative Easing works and the effects of Quantitative Easing on a …
Read More
pexels karolina grabowska 4386372 scaled

11. Taxes

This article will go through the different types of taxes and will explain where the incidence of taxes lies. Furthermore, the article will outline how …
Read More
Consumer and producer surplus, consumer surplus, producer surplus

10. Consumer and Producer Surplus

This article will explain consumer and producer surplus are and will also discuss the impact of increases in consumer and producer surplus. Furthermore, the article …
Read More
Balance of payments, current account

4. Balance of Payments

Balance of payments. The UK balance of payments current account for Q1 (2020) is sitting £-2.1 billion This article will explain what the balance of …
Read More
Employment and unemployment, employment, unemployment, PPF,

3. Employment and Unemployment

Employment and unemployment. This article will explain what unemployment is and how it is measured. Furthermore, the article will discuss the causes of unemployment and …
Read More
  1. ae9b9d3b9e4c72e013486a017075edee?s=48&d=mm&r=g
  2. 530fe42f3fcb85bb6d657763720a0231?s=48&d=mm&r=g
  3. 7178776bb1ed6fee8ac28eb8b08316bc?s=48&d=mm&r=g

Processing…
Success! You're on the list.
0 0 votes
Article Rating
Subscribe
Notify of
guest
0 Comments
Inline Feedbacks
View all comments
0
Would love your thoughts, please comment.x
()
x