Theory question 108
Public Finance(a) What is a specific tax?
(b) Explain with the aid of diagrams, the effects of specific tax on a commodity that has a: (i) perfectly elastic demand; (ii) perfectly inelastic demand.
(c) State two differences between a direct and an indirect tax.
Show the model answer
(a) A specific tax is a fixed amount of tax per unit of a commodity, regardless of its value (e.g. N10 per litre).
(b) The tax shifts the supply curve upward by the amount of the tax.
(i) Perfectly elastic demand (horizontal D): price stays the same, quantity falls; the whole tax is borne by the producer (seller).
(ii) Perfectly inelastic demand (vertical D): quantity stays the same, price rises by the full amount of the tax; the whole tax is borne by the consumer.
Diagrams: D, S0, S1 (shifted up by the tax), old and new price and quantity labelled.
(c) Any two: direct tax is on income/property, indirect on goods and services; burden of a direct tax cannot be shifted, that of an indirect tax can be; direct tax is usually progressive, indirect tax regressive; direct tax paid directly to government by the taxpayer, indirect tax collected through sellers.
Incidence falls on whichever side of the market is less able to respond.