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Taxes

Taxes 

An indirect tax is a tax on good and services rather than on income or profits (which is direct tax). It increases the cost of production of a good or service. 

Indirect taxes come in two forms: 

Specific tax - a tax charged as a fixed amount per unit of a good. (e.g 10p per cigarette) 

Ad valorem tax - a tax charged as a percentage of the price of a good. (e.g 20% VAT) 

The tax increases the cost of producing a good, and this increase in the cost of production shifts in the supply curve. With specific tax it shifts in a fixed amount at all points, so the amount of the tax can be measure by the vertical distance between the initial supply curve and the new supply curve. 

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Specific tax

With ad valorem tax the supply curve shifts in a greater amount as you move further up the supply curve. 

Ad valorem tax

Both the consumer and producer are made worse off by the tax - they both have to pay, and the amount which they have to pay is the incidence. The amount of producer and consumer incidence ultimately depends on the price elasticity of demand and of supply of the product. When the PED of a product is elastic (and PES inelastic), the incidence falls more heavily on the producers side because if they pass more onto the consumer, the quantity demanded will fall sharply and the firm is likely to lose a lot of business. However if the PED is inelastic (and PES elastic), the producer can easily pass on more of the burden of the tax to the consumer, knowing that increasing the price the consumer has to pay will not greatly affect the quantity demanded of the product. 
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Ad valorem tax with relevant labels 
In the above diagram, the consumer incidence is the area from P1 to P0 and the producer incidence is the area between P0 and X. The triangle with co-ordinates (Q1,P0), (Q0,P0), (Q0,P1) represents deadweight loss. This is the value destroyed by the tax - goods/services that would have otherwise been produced and consumed before the tax no longer are. The value of these goods is destroyed as they are no longer produced. The area between P1 and X is the government revenue collected from the tax. 
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