Top 3 misconceptions about Indirect Taxes
Welcome back to our lost and found series where we cover the misconceptions that we as students faced and help them get back on the right track!
This week, we will be looking at Taxes!
Difference Between Specific And Ad Valorem Taxes
Students often get confused with these 2 taxes, not because they mistake them for each other but rather they misunderstand them individually.
Let’s look at specific taxes first. They are a fixed amount of tax per unit of good or service sold.
In this case, the keyword here is tax per unit. This means that a tax is imposed on every unit. So if the tax per unit is $2 then if I sell 5 units, the total tax I would pay is $2 X 5 = $10. Therefore, since specific tax is in the tax per unit form, we just have to multiply it by the Quantity.
Now, the more confusing one, Ad Valorem taxes. Ad Valorem taxes are a fixed percentage of the price of the good or service. How to calculate Ad Valorem tax is different from Specific Tax. The tax is now not constant and therefore, to calculate the tax per unit, we have to multiply the tax percentage by the price of the good. So for instance, if the percentage given is 7%, then the tax per unit for a good that costs $100 and a good that costs $10 will be different. The good that costs $100 will incur a $7 tax per unit whilst the good that costs $10 will incur a $0.7 tax per unit. To calculate the total tax, multiply the tax per unit by the Quantity sold.
2. Effect of Taxation On The Supply Curve.
Students get confused with this as they may associate the change in the Supply equation with the Supply curve.
For the Supply Curve, the new curve is labelled as S1 + tax.
For the Supply equation, it becomes Qs = c + d(P-t)
Students may be wondering why it is an addition in the Supply Curve but a subtraction in the Supply Equation.
The way I think about it is that the curve is shifted upwards thus, an addition.
For the equation, I think about it as Producers (which Quantity Supplied reflects the producers side), receive a lower price, thus a subtraction.
3. Which stakeholder bears the most burden?
The best way to figure out tax incidence is to simply draw it out. We are able to see which stakeholder is more affected by seeing how much their respective prices change.
Recall that without taxation, consumers pay the same amount as what producers receive. However, with a taxation imposed, consumers pay a different amount from what producers receive. Why is this the case? Because the difference is essentially the tax per unit!
(Amount consumers pay per unit) - (Tax per unit) = (Amount producers receive per unit)
So, in order to figure out which stakeholder bears the bigger burden, we just look at the difference between what consumers initially paid (which is also what producers initially receive, i.e. Pe) and what consumers pay with the taxation. Then, we compare this to the difference between what producers initially paid and what producers receive with the taxation. The stakeholder which has the bigger difference, has the larger burden.
If all else fails and you have no idea what I just wrote above, you can always refer to the “formula”:
Tax incidence of consumers = (Pc -Pe) X Qt
Tax incidence of producers = (Pe-Pp) X Qt
That’s it for this week’s Lost and Found series! I hope this has been helpful and if you want to request any particular topic, please drop us an email at ibloungesg@gmail.com.
Alternatively, you may consider receiving help from our Economics tutor right here! They have both achieved a grade 7 in Economics as well as above 40 points for IB!
