CIMA BA1 Syllabus B. Microeconomic And Organisational Context Of Business - Government intervention - indirect taxes - Notes ^{6 / 9}

Indirect tax

An indirect tax is a tax levied on spending. 

The Supplier is responsible for collecting and paying the tax to the government, but much of the tax is passed on to the consumer (due to a higher price being charged).

A key purpose of an indirect tax is to reflect social costs by adding them as a cost to be paid by the Supplier. 

This will result in less of the product being consumed, which is especially desirable in the case of demerit goods such as alcohol.

Consumer's & Supplier's Portion Tax

Step 1: Price increases (due to an Indirect tax)

• Supplier is prepared to sell MORE

• Supply Curve moves LEFT S -> S1

Step 2:

• What is the new price when D = S? A

• What is the old price when D = S? C

• What is the difference in Price? A -> C

Step 3:

• Consumer Pays the difference in Price (AC)

• Supplier Pays the rest (CB)

Illustration 1

The price of a bottle of rum is $10. 

At this price, the amount consumed is Q0. 

If the government imposes an indirect tax of $5 per bottle, this is paid to the government by the supplier. 

The supplier will now only be prepared to sell the same quantity when the price is $15 per bottle (rather than $10). 

Therefore, the supply curve moves up by $5 from S0 to S1.

However, at this new price of $15, demand for rum will be lower. 

There is now a surplus of rum (Q1 — Q0), so rum producers will cut their price until the surplus is removed at B, where price is $13.

As a result of the tax, price rises by $3 (from 10 to 13) — so $3 of the tax is passed on to the consumer.

The rest of the burden of the tax ($2) is borne by the supplier.

Price elasticity and the impact of indirect taxes

The impact of an indirect tax will be that the price of the good rises, and that the quantity produced and sold falls. 

The extent to which a price rise causes a fall in quantity depends on the price elasticity of demand and supply.

• If the price elasticity of demand is very low (inelastic) then the quantity demanded will not fall significantly as a result of a price rise.

• If the price elasticity of supply is very low (inelastic) then the quantity supplied will not fall significantly, and in some cases supply may be fixed in the short term regardless of price

  eg output of gas from a tracking site.

So the imposition of an indirect tax may not achieve a significant reduction in the consumption of a demerit good.

However, it can still raise useful income to finance government spending and to force producers to bear some of the costs of managing the negative externalities resulting from production.