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Indirect Taxes in a Mixed Economy and Consumer Surplus

‘Indirect taxes reduce consumer surplus and should therefore never be imposed in a mixed economy.’ Discuss this view. [12]

Category:

Taxes and subsidies

[CIE AS level May 2018]

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Answer


Step ➊ : Define indirect taxes, consumer surplus and mixed economy the introduction.

It is often argued whether indirect taxes reduce consumer surplus and whether it should be imposed in a mixed economy. An indirect tax is a tax that is levied on goods and services. Examples of indirect taxes include excise duty, value added tax and custom duty. A mixed economy means that part of the economy is left to the free market, and part of it is managed by the government. Consumer surplus is the difference between the value a consumer places on units consumed and the payment needed to actually purchase that product. Several factors should therefore be taken into consideration before imposing an indirect tax.


Step ➋ : Explain how indirect taxes reduce consumer surplus and why this may be a disadvantage to the consumer.

Indirect taxes may be a disadvantage to consumers since they reduce consumer surplus in a mixed economy. Consumer surplus before the imposition of an indirect tax is represented shaded area under the demand curve and above the price line in figure (a). This represents the difference between the total value consumers place on all the units consumed and the payments they need to make in order to actually purchase that commodity.

When the government imposes an indirect tax, the supply curve shifts upwards from S to S+tax. Price rises from P1 to P2 and quantity falls from Q1 to Q2. As price increases, the consumer surplus is reduced as some consumers are unwilling to pay the higher price. This reduction is shown in figure (b). The loss of consumer surplus is shown by the area P1P2E1E.

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Thus indirect taxes can have a negative effect if imposed on basic commodities such as food and clothes. Consumers will experience a fall in purchasing power. Since the indirect tax raises the prices of taxed commodities, it can prevent people from consuming those commodities. This is even worse for the poor or low-income workers.

Not only indirect taxes reduce consumer surplus, but they are also regressive in nature. When a tax is regressive, the poor pay a higher proportion of their income as tax or they pay the same amount of tax as the rich. For example, if the tax on a commodity is 10%, whether somebody is rich or poor, they will pay the same 10%. An indirect tax will therefore affect the very poor more than the rich. This is because the poor have to use a much greater percentage of their income to pay the tax. The rich, on the other hand, barely feel the tax on the commodity.

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Step ➌ : Discuss why indirect taxes may be necessary.
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However, even though an indirect tax reduces consumer surplus, it does not mean that they should not be imposed in a mixed economy. This is because in a mixed economy, the free market can cause market failures. For example, there may be an overconsumption of demerit goods such as cigarettes and an underconsumption of merit goods such as education. Public goods cannot be provided in the free market because of the free-rider problem. Consequently, there may be the need for government intervention in order to correct these market failures. We will see that taxation can be used to discourage the consumption of demerit goods and raise revenue to fund merit goods and public goods.

➤ 3.1 Indirect tax constitutes a very huge source of revenue for the government since the tax net covers a much wider area.

Indirect taxes are considered a huge source of revenue for governments in a mixed economy. This revenue can be used in sectors such as education and healthcare. Education and healthcare are examples of merit goods that tend to be underconsumed and underproduced. Revenue from indirect taxes can also be used to fund public goods such as defence. This will help to improve living standards.

➤ 3.2 Indirect taxes can be used to control the consumption of certain harmful goods.

The fact that indirect taxes reduce consumer surplus can be an advantage in this case. In order to discourage the consumption of a harmful demerit good such as cigarettes, the government can raise taxes on cigarettes in order to increase the price. When the price is increased, consumers can’t afford to buy demerit goods like before. Indirect taxes, therefore, can help to reduce the consumption of demerit goods.

➤ 3.3 Indirect taxation can be a very powerful tool in protecting infant or home industries against foreign competition.

Indirect taxes can also be used to prevent the dumping. Dumping occurs when foreign firms dump products at artificially low prices in a country. The government can prevent dumping by placing very high tariffs. A tariff which is an example of an indirect tax on imported goods. This raises the prices of these imported goods and discourages people from consuming them. The end result is that local industries are protected and the dumping of certain commodities in the country.

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Step ➍: Conclude.
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To conclude, it is true that taxes reduce consumer surplus and may considerably impact lower-income families, however, this does not mean that indirect taxes should never be imposed. Indirect taxes should be imposed in some cases even if it reduces consumer surplus. It can be used to correct market failures such as pollution and the consumption of demerit goods. Taxes are a valuable source of revenue to the government in a mixed economy and is used to finance merit goods such as education and public goods such as defence. Consequently, indirect taxes should be imposed reasonably.

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♕ Marking schemes
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Up to 8 marks for analysis
• Of the negative impact of the imposition of an indirect tax upon consumer surplus; higher prices and lower consumer surplus and lower consumption of the good overall. Also allow broader considerations such as the fact that the tax is regressive and could contribute to costpush inflation (up to 4 marks)
• Of the positive effects of imposing indirect taxes such as discouraging the consumption of demerit goods, raising revenue, tariffs are indirect taxes that discourage imports and so on (up to 4 marks) Up to 4 marks for evaluative comment with 1 mark reserved for a reasoned conclusion on whether indirect taxes should ever be imposed.

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♕ Guidance
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The imposition of an indirect tax distorts the market in the sense that the price signals from the consumer do not reflect the value that consumers place upon the good. In addition, consumer surplus and producer surplus are reduced. In the case of demerit goods however indirect taxes adjust demand to overcome the problem of imperfect information. Candidates can be rewarded for discussion of the revenue raising motive for imposing taxes.

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♕ Examiner's reports
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Most candidates provided good analysis to explain why indirect taxation is necessary. Many focused upon the need to apply indirect taxes to demerit goods to reduce their consumption. In addition, many provided analysis of the way in which revenue raised from indirect taxes could provide funds for government expenditure. Many were less successful when attempting to explain why indirect taxes should not be imposed as suggested by the quotation in the question. Many stated that such taxes would reduce consumer surplus, but few developed this to support the sentiment expressed in the quotation. As a result this meant that many answers were unbalanced and this undermined the ability of candidates to provide evaluative comment and arrive at a reasoned conclusion.

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