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

Market failure

[CIE AS level May 2018]

⚠️ Warning : Essay models like this one will help you understand how to write and structure your essay. However, do not make the mistake of reproducing pre-prepared answers in your exam. Each exam question is unique and should be tackled in accordance to the context of the question.


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

In a mixed economy, some resources are owned by the public sector (government) and some are owned by the private sector. A form of government intervention in a mixed economy is to impost an indirect tax. An indirect tax is a tax that is levied on goods and services, VAT for example. Indirect taxation is said to reduce consumer surplus. Consumer surplus arises because some consumers are willing to pay more than the given price for all but the last unit they buy.

It is said that indirect taxes reduce consumer surplus and should therefore never be imposed in a mixed economy. We will discuss assertion may be correct but only to an extent. Several factors should be considered before imposing an indirect tax.

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

💰It is true that indirect taxes may be a disadvantage to consumers because they reduce consumer surplus.

This can be shown using a diagram.


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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.

💰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.

Step ➌ : Discuss why indirect taxes may be necessary.

Even though an indirect tax reduces consumer surplus, this does not mean that they should not be imposed in a mixed economy. Indirect taxes can be used to correct market failures in a mixed economy. It is also a significant revenue for the government.

💰 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. This revenue can be used for government spending in critical sectors such as education and healthcare. This will help to improve living standards.

💰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 good such as cigarettes, the government can raise taxes on cigarettes in order to increase the price. When the price is massively increased, consumers can’t afford to buy it like before and this, therefore, reduces the consumption of cigarettes.

💰Tariffs, which is an example of an indirect tax on imported goods, can be used to prevent the dumping of certain undesirable commodities in the country.

Dumping occurs when foreign firms sell their products in large quantities at prices deliberately below those charged by domestic firms, often even below the cost of production. High tariffs raises the prices of 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 is mitigated. Indirect taxation can be a very powerful tool in protecting infant or home industries against foreign competition.

Step ➍: Conclude.

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 healthcare. Consequently, indirect taxes should be imposed reasonably.

♕ Marking schemes
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.

♕ Guidance
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.

♕ Examiner's reports
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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