(a) Explain the following types of taxes:
→specific tax
→value-added tax
(bi) With the aid of diagrams, describe the effects of an indirect tax on a commodity when demand is:
perfectly inelastic
(ii) With the aid of diagrams, describe the effects of an indirect tax on a commodity when demand is:
perfectly elastic
Explanation
(a) →A specific tax is a tax that is levied on a fixed rate per unit of output i.e it is a fixed tax sum imposed per unit of a commodity.
→Value added tax are tax levied on businesses at every stage of production and distribution. VAT was introduced in 1994 to replace sales tax and it is a type of indirect taxes.
(bi) The effects of an indirect tax on a commodity when demand is perfectly inelastic is borne by the consumer. In this case, the whole tax burden can easily be shifted to the consumer by the producer or seller in the form of higher prices because the increase in price does not bring any change in quantity demand.
From the diagram above, the tax is represented by AB. This tax increases the manufacturer's cost of production. Since the same quantity is purchased irrespective of the price, the manufacturer increases the price of the production from P1 to P2. The consumer bears the full burden represented by rectangle P1BAP2.
(ii) If the demand for a commodity is perfectly elastic, the producer or seller will bear the whole burden of taxation. This is so because any attempt to increase price will make the demand for the product fall to zero. The tax burden under this condition cannot be passed to the consumer.
In the diagram above, the tax is represented by EF. Since the tax increases the manufacturer's( seller) cost of production, the quantity supplied decreased from Q1 to Q2. However, the price remains at P since any attempt to increase price will make demand to drop to zero. The manufacturer or seller, therefore, bears the whole tax burden represented by rectangle PEFG.