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Indirect Taxes

Effects of Indirect Taxes on Consumer & Producer Surplus

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  • Initially, the market is at equilibrium where demand (MB) and supply (MS) intersect, with equilibrium price and quantity P* and Q* -> after an indirect tax of ____ imposed to ____ -> producer's cost of production increases -> producers less willing to supply -> less quantity supplied -> Q* contracts to Qt -> S1 shifts leftward to S2 creating new equilibrium where MB and S2 intersects

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  • New equilibrium at a higher price for consumer (Pc) and producers receives at a lower price (Pp) because less quantity sold -> therefore, tax burden is shared among consumers and producers

    • consumers pay Pc-Pp more per unit​

    • producers receives P*-Pp less per unit

  • However, gov receives Qt × (Pc-Pp)

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  • As a result, allocative inefficiency in the mkt & creating DWL of area a&b

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Diagram Explanation:

Evaluation for diff stakeholders:

1) Consumers:

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  • If taxed good is harmful to human health -> reduced consumptions may lead to positive externalities -> improved health -> better off

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  • Price rises -> reduced purchasing power -> goods are less affordable than before -> reduced living standards -> worse off

  •  If good (tobacco/alcohol) is price inelastic -> consumers cannot find cheaper substitutes in short term -> burden falls more on low-income groups -> worse off

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2) Producers:
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  • Tax imposed -> higher prices -> lower Qd -> lower Qsold -> receives lower revenue & profit -> worse off

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3) Government:

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  • Tax imposed -> earns higher revenue from tax collections -> use on public spendings (healthcare/ education/ correct negative externalities/ support low- income households) -> gain political supports -> better off

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  • May cause consumers/producers to be angry -> instability -> more crimes perhaps

  • Consumers may seek g&s in black mkts -> gov needs to spend more costs to combat with these illicit mkts -> opportunity costs -> worse off 

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4) Workers:

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  • Tax imposed to harmful goods -> reduction in consumptions may improve public health in LR -> resulting in healthier workers ->  productivity higher -> earn more wages -> better off

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  • Producers face higher production costs due to indirect taxes and lower Qs -> may respond by:

    • cutting working hours -> workers receive less wages -> afford less goods -> living standards reduce

    • laying off workers -> workers unemployed

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