Indirect Taxes

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Using the appropriate diagrams, explain why the relative burden (incidence) of an indirect tax on the producers & on the consumer varies depending on the price elasticity of demand for the good/product.

Indirect Tax is a tax placed upon the selling price of a product, so it raises the firm’s cost and shifts the supply curve left or vertically upwards depending on the amount of tax. Because of this shift, less products will be supplied at every price. The diagram below shows the effect of imposing a tax and how the tax is being paid.

There’re two types of indirect taxes, they are ‘Specific Taxes’ and ‘Ad Valorem’. Specific Tax is a fixed amount of tax that is imposed on a product. For example, if the government imposes a tax of $2 per loaf of bread, it will shift the supply curve vertically upwards by the amount of tax, which is S2. This is shown by the diagram below.

Ad Valorem, also known as ‘percentage tax’, is a percentage of tax from the selling price of a good. In this case, the supply curve will not shift directly upwards because the gap between the ‘price’ and the ‘price + tax’ will get bigger as the price rises. For example, a packet of cigarette costs $10. If the government imposes a 20% tax per packet, the tax on each packet of cigarette would be $2. This is shown by the diagram below.

When the government puts a tax on a product, the product’s price will usually increase in order to achieve maximum profit. Which means that the quantity demanded for the product is likely to decrease. If the demand for a product is very elastic, then a price increase as a result of the imposition of a tax on the product will lead to a relatively large fall in the demand for the product. For example, Waitrose pasta and Tesco Value pasta both cost $5 per pack. However the price of Waitrose pasta increases to $6 because of the rise in tax. This would result an immediate change in demand from Waitrose pasta to Tesco Value pasta instead. This means that the...
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