Indirect Tax (15)

For consumers, an indirect tax increases the price of the taxed good, which may reduce its affordability and consumption. This could be seen as a negative effect for consumers, as they may have to pay more for the good or switch to alternative products. In the diagram above we can see that the consumer surplus decreases from ABE to CDE. However, in some cases, the reduction in consumption resulting from the tax could have positive effects on consumer welfare, especially if the taxed good is a demerit good with negative externalities. For example, the United Kingdom imposes a high tax on cigarettes and alcohol, which aims to reduce consumption and mitigate the negative health effects associated with smoking and excessive alcohol consumption. While some consumers may view the higher prices as detrimental to their utility, the reduced consumption of harmful goods could lead to improved public health outcomes in the long run.

For producers, an indirect tax can reduce the quantity demaned for the taxed good, leading to lower sales and potentially lower profits. In the diagram above, we can see that the producer surplus falls from ABD to GFH.  In response to the tax, producers may need to adjust their production levels or seek ways to reduce costs in order to maintain profitability. For example, tobacco companies faced with high cigarette taxes may need to invest in alternative products, such as e-cigarettes or other less harmful alternatives, to maintain their market position. However, producers of goods with inelastic demand, such as cigarettes, may be able to pass on the majority of the tax burden to consumers, limiting the impact on their profits and actually having a more detrimental impact on cigarette consumers. This is especially a problem as the tax is likely to be regressive, hurting those on lower incomes to a much larger extent than those on higher incomes who are able to absorb the tax with no impact on their overall disposable income and thus spending.

For the government, imposing an indirect tax on a particular good can generate revenue that can be used to fund public services, reduce budget deficits, or finance other government initiatives. In this sense, indirect taxes can be an important source of government revenue, particularly for goods with inelastic demand, where the tax-induced reduction in consumption is relatively small. However, the government may also face trade-offs between raising revenue and achieving other policy objectives, such as reducing consumption of harmful goods or addressing income inequality. For example, while taxes on goods like cigarettes and alcohol can generate significant revenue, they can also be regressive as explained above, disproportionately affecting low-income households who spend a larger share of their income on these goods. This could lead to other social issues which will need address and thus require further government spending.

In conclusion, the effects of an indirect tax on stakeholders can be varied and depend on the specific good being taxed and the objectives of the policy. While consumers may face higher prices and reduced consumption, the long-term welfare effects could be positive if the tax targets demerit goods with negative externalities. Producers may experience reduced demand and profitability but may also adapt by diversifying their product offerings or passing the tax burden onto consumers. Finally, the government can benefit from increased revenue, but may need to balance this objective against other policy goals, such as reducing consumption of harmful goods and addressing income inequality.