3.2 Methods and Effects of Government Intervention in Markets

1. Impact and Incidence of Specific Indirect Taxes

What is an Indirect Tax?

An indirect tax is a tax placed on goods and services — not on your income. When you buy a product that has an indirect tax on it, part of the price you pay goes to the government. The seller collects the tax and passes it on to the government.

Examples of indirect taxes include sales tax, value-added tax (VAT), and taxes on cigarettes or petrol.

There are two types of indirect taxes:

• Specific tax — a fixed amount of tax charged per unit of a good. For example, a tax of USD 2 per packet of cigarettes. On a supply-and-demand diagram, a specific tax shifts the supply curve straight up (a parallel shift) by the amount of the tax.
• Ad valorem tax — a percentage of the price. For example, a 15% tax. The higher the price of the good, the larger the tax amount. On a diagram, this causes a non-parallel leftward shift of the supply curve (the gap between old and new supply curves gets wider as price rises).

Impact of a Specific Indirect Tax

When the government puts a specific tax on a good, the cost of producing and selling that good goes up for firms. This causes the supply curve to shift to the left (or upward) by the amount of the tax. This means:

• The price consumers pay goes up
• The quantity bought and sold goes down
• Government collects tax revenue

Let's trace this step by step:

1. Government imposes a tax of, say, USD 4 per unit on a good.
2. This raises firms' costs. The supply curve shifts left by USD 4.
3. The new equilibrium price rises — but usually by less than USD 4.
4. Consumers now pay a higher price (Pc) than before.
5. Sellers receive a lower price (Ps) than before, after handing the tax to the government.
6. The gap between Pc and Ps equals the tax amount.

Incidence of a Specific Indirect Tax

Incidence means: who actually ends up bearing (paying) the burden of the tax? Even though firms collect the tax, both consumers and producers share the burden.

• The consumer burden is how much extra the consumer pays compared to before the tax.
• The producer burden is how much less the producer keeps after paying the tax.

How incidence is split depends on price elasticity of demand (PED) and price elasticity of supply (PES):

Plain-English explanation: If consumers really need a good and won't stop buying it when prices rise (inelastic demand), they end up paying most of the tax. If firms can easily stop producing (elastic supply), they shift more of the burden onto consumers. Whoever is less flexible (less elastic) ends up paying more.

Two extreme cases:

• If demand is perfectly elastic — consumers will buy nothing if the price rises, so the entire tax burden falls on the producer.
• If supply is perfectly elastic — producers will not supply at all if their price falls, so the entire tax burden falls on the consumer.