Taxation

Key Terms
Indirect Tax: A tax on spending

Direct Tax: A tax, such as income tax, which is levied on the income or profits of the person who pays it, rather than on goods or services.

Demerit Goods: A good that would be over-consumer in the free market and creates negative external costs to third parties.
Theory

Specific Taxation

specific taxation diagram

In the free market price and quantity are P1 and Q1. S = MPC.

However if the external costs MEC are taken into account the supply curve should be at S + Tax, giving the socially optimal out put Q2.

The government therefore impose a tax which is equal to the MEC (marginal external cost) which shifts S (MPC) to S + Tax (MSC).

  • Note: The amount of tax is greater than the change in price

  • P1 – P2 of the tax is paid by consumers

  • The rest is paid by the producers

  • The more inelastic the higher the tax burden on the consumer.


    • Ad Valorem Taxation

    ad valorem tax diagram

    Ad Valorem causes a non-parallel shift of the supply curve. This is because ad valorem tax is always the same percentage of the price, therefore higher prices cause a steaper curve.

    Regardless of the non-parrallel shift, the burden of tax on the consumer and producer is calculated in exactly the same way as a specific tax.
    Advantages of Taxation
    1) Reduced consumption of demerit goods

    Increasing the price of demerit goods such as alcohol will offset demand. However this depends on the elasticity of the good. Alcohol is addictive and therefore may have inelastic PED.



    2) Requires little management by the government once it is imposed



    3) A source of revenue for the government

    This can then be allocated elsewhere in the economy. However direct tax on company could be avoided by moving headquarters.



    4) Increased efficiency

    Direct taxation reduces profit for firms, therefore producers may be encouraged to be more efficient in order to reduce costs and maintain profit.
    Disadvantages of Taxation
    1) Punishes the responsible consumer

    Tax on demerit goods may punish people who consume the good responsibly.



    2) Time Lag

    Changes in tax are made only once a year in the governments budget.



    3) Tax = Higher Prices for consumers

    If demand for a demerit good is inelastic, firms can simply pass on the taxation to the consumer in the form of higher prices, in turn firms make more profit.

    To make matters worse, profit could be reinvested by the firm to make the good even more desirable e.g. through advertising
    Evaluation
  • The effectiveness of taxation depends on whether demand is elastic or inelastic

  • Effect depends on type of tax (direct or indirect)

  • Direct tax on company could be avoided by moving headquarters


  • Changes in tax may conflict with other government objectives e.g. Unemployment if firms face higher costs

  • Increasing one type of taxation often means reducing another type e.g. Income tax

  • Taxation on demerit goods require value judgements to be made e.g. how much of a burden is the good to society. Some individuals will feel more strongly than others.









    • ↑