Theory question 106
Public Finance(a) Explain the following types of taxes: (i) specific tax; (ii) value-added tax.
(b) With the aid of diagrams, describe the effects of an indirect tax on a commodity when demand is: (i) perfectly inelastic; (ii) perfectly elastic.
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(a)(i) Specific tax: a fixed amount of tax per unit of a commodity, whatever its price (e.g. $2 per litre).
(ii) Value-added tax: a tax charged at each stage of production and distribution on the value added at that stage, finally borne by the consumer.
(b) The tax shifts the supply curve upward by the tax.
(i) Perfectly inelastic (vertical) demand: quantity is unchanged and price rises by the full tax; the consumer bears all of it.
(ii) Perfectly elastic (horizontal) demand: price is unchanged, quantity falls; the producer bears all the tax.
The side of the market that cannot respond bears the tax.