A tax on each unit sold raises firms' costs, so supply falls, price rises and quantity falls.
An indirect tax is a tax on spending. It is collected from firms when goods are sold, such as a fixed tax on each pack of cigarettes. It raises firms' costs, so supply decreases. On a diagram, supply shifts up by the amount of the tax.
Price rises and quantity falls. Governments use indirect taxes to cut consumption of demerit goods and goods with external costs, and to raise revenue.
Advantages: the tax discourages harmful consumption and raises money for public services. It also makes buyers pay more of the true cost of what they consume.
Disadvantages: if demand is inelastic, consumption falls only a little. The tax takes a bigger share of poorer people's incomes. Very high taxes can encourage smuggling and illegal sales.
- Indirect tax
- Tax on spending; supply shifts up by the tax.
- Effect
- Price rises, quantity falls, government gains revenue.
- Limit
- With inelastic demand, consumption falls little.
Worked example: A tax on sugary drinks
Suppose a government places a tax of 20 cents on every can of sugary drink.
- Supply shifts up by 20 cents to S + tax, because each can now costs firms more to sell.
- The price buyers pay rises, so quantity demanded contracts and fewer cans are sold.
- The government collects 20 cents x the new quantity as revenue.
- How far consumption falls depends on PED: with many substitutes, demand is elastic and it falls a lot.
Watch out for this
An indirect tax shifts the demand curve to the left.
The tax is collected from sellers, so it raises their costs and shifts supply. Quantity demanded falls because of the higher price, which is a movement along demand.
Check your understanding
A government places a tax on each litre of petrol sold. What happens in the market?
- Supply decreases, so price rises and quantity sold falls.
- Demand decreases, so price and quantity both fall.
- Supply increases, so price falls.