While this lesson focuses on the impact of indirect taxation on a good or service there is also a discussion of how taxes are spent and reasons why a government places a tax on a good or service. Your classes will need to understand that when a government places an indirect tax on a good or service then this raises the price of the product, reducing the quantity purchased.
Students should also be able to make the link between the tax placed on certain items and the provision of public services which governments finance out of tax revenues.
Enquiry questionAn understanding of why governments place taxes on goods and services and a recognition that goods and services respond differently to the imposition of a sales tax.
Lesson time: 90 minutes
Understand why governments impose indirect taxes on different goods and services
Distinguish between specific and ad valorem taxes
Illustrate using diagrams the impact of specific and ad valorem taxes on the market for different products
Discuss the consequences of imposing an indirect tax on the stakeholders in a market, including consumers, producers and the government.
1. Beginning activity
Draw three supply and demand curves in your notebooks. These diagrams should be for products with different PED elasticity, e.g. cigarettes, used cars (unitary PED) and a good with elastic PED. Draw the impact of a sales tax on the good or service, including the new equilibrium points. Be careful that you do not illustrate the impact of the tax by changing the demand curve, rather than supply.
(a) Highlight the burden of tax paid by the consumer, in the form of higher prices and lost consumer surplus and the burden paid by the producer, in the form of lost sales and lower profit margins.
(b) Which of the three products provides the government with the most tax revenue?
(c) Which has the most significant impact on reducing sales for the product?
Indirect tax - tax placed on a good or service, raising the production costs of the business. It is a tax on expenditure rather than a tax on income.
Specific tax - this is a fixed amount placed upon a good or service, e.g. a government may impose a specific tax of say $ 4 on each pack of cigarettes sold.
Ad valorem tax - this is a tax placed on a range of goods and services which is a percentage of the total selling price. For example in the EU the majority of states place a 20% tax on the sale of most goods and services.
Producer taxes - a tax on sales but paid for by the manufacturer or producer, rather than the consumer.
Excise taxes - taxes applied to a narrow range of products, such as cigarettes or alcohol. These are imposed to reduce consumption of those products.
Import tariffs - a tax on imported goods designed to protect domestic industry.
Incidence of taxation - the share of tax paid by both the consumer, in the form of higher prices / lower consumer surplus and the share paid by the producer in the form of lost sales and lower producer surplus.
The class handout can be accessed as a PDF file at: Sales taxes
Start by watching the following short video and then complete the tasks that follow:
(a) Add a flat rate indirect tax to the following diagrams and then answer the questions that follow:
(b) Illustrate the change in price and quantity demanded for each of the three products, highlighted in the diagrams above.
(c) Illustrate the change in consumer and producer surplus resulting from the indirect tax.
Activity 2: Research activity
Sales tax can be divided into general sales taxes applied to all goods and services and specific taxes on certain products, that the government wishes to reduce the consumption of. Examples might include taxation placed on tobacco and alcohol products while some governments place taxes on luxury goods imported from overseas.
Research the goods and services that your government places a specific tax on and decide the likely motivation for the tax?
The diagram to the right illustrates the market for a good.
(a) Illustrate the impact of a tax on the market for this good by drawing a new supply curve to the left of the original.
(b) Illustrate the new equilibrium price and quantity.
(c) Illustrate the burden of tax paid by both the consumer and producer and the 'dead weight' loss.
The diagram to the left illustrates an ad valorem tax, a fixed percentage tax, added to the production cost of the good or service.
(a) Explain why the new supply curve is not parallel to the original, as with a fixed rate tax.
(b) Explain one advantage of a % tax over a flat rate indirect tax.
Draw the impact of a percentage or ad valorem tax on the product, represented by diagram 1. On diagram two, illustrate the impact of a flat rate tax on the same good or service.
The table below shows the demand and supply schedules for a good:
(a) What is the initial equilibrium price and quantity?
The government imposes a tax of $2 per unit, with the new supply schedule as shown in column 4.
(b) Find the new equilibrium price after the tax has been imposed
(c) Calculate the total tax revenue going to the government
(d) How have consumers and producers been affected by the sales tax?
Activity 7: Countries with the highest sales tax
Nations with the highest sales tax in 2020 are represented on the following diagram:
|Rank||Country||Sales tax rate %|
(a) Describe the likely impact of high sales tax rates on levels of investment within a nation?
(b) Describe some of the benefits of generating tax revenue from indirect taxation?
(c) Outline some of the weaknesses of indirect taxes?
Activity 8: Should marijuana be taxed
Start this activity with a short vote on the question, should the narcotic be legalised or not?
Now watch the following short video which argues that the production of marijuana should be legalised and then subject to a sales tax, just as cigarettes and alcohol are under the current law in America. Summarise the main arguments for and against the legalisation of this product? Has the video in anyway changed you opinions on the merits of legalising the product?
9. Link to the assessment
Government intervention from a microeconomics perspective can be found in papers one and three. Examples of paper one questions include:
Explain why governments impose indirect taxes on specific goods and services. [10 marks]
Using real world examples, evaluate the effectiveness of indirect taxes in reducing the consumption levels of demerit goods such as tobacco, petrol and alcohol products? [15 marks]
Relevant questions from the paper three exam might include illustrating the impact of an indirect tax on a good or service, using a given set of data. Paper three questions on this topic might also require candidates to calculate the change in price / quantity demanded or the size of the consumer and producer surplus, after the imposition of a sales tax.
10. Further reading
Can be accessed at: //ourworldindata.org/taxation