Direct & Indirect Taxes (AS/A LEVELS/IB/IAL)

Direct & Indirect Taxes (AS/A LEVELS/IB/IAL)

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Level: AS Levels, A Level, GCSE – Exam Boards: Edexcel, AQA, OCR, WJEC, IB, Eduqas – Economics Revision Notes 

Taxes

A tax is a compulsory charge on the price of goods and services. Taxes are also charged on incomes and capital.

  • Taxes will make the price of a good higher and shift the supply curve to the left.
  • Taxes are collected by the government to provide public goods to society such as street lighting, the police force, dams and roads etc.

There are two types of taxes:

  1. Direct taxes
  2. Indirect taxes

Direct Tax

Definition

A direct tax is paid directly to the government. It is levied on individuals or companies.

Direct Tax – Examples

  • Income tax is a direct tax on an individual’s income. It normally comes out of their pay before they receive their payslip.
  • Corporation tax is also a direct tax on a company’s profit. The current rate of corporation tax in the U.K. (2016) is 20%.

Indirect Tax

Definition

An indirect tax is a tax on expenditure.

There are two types of indirect tax:

  1. Specific Tax
  2. Advalorem Tax

Specific Tax

  • A specific tax is a fixed amount per unit of a good. E.g. cigarettes, wine and beer
  • E.g. if a product was purchased for £10 and the specific tax on this product was £2. If the price of this product increased to £20 the tax on this product would still be £2. The tax amount stays fixed regardless of changes in price.
  • A specific tax causes a parallel shift of the supply curve to the left as shown below.

 

 

Calculating the tax area:

Whole Tax = (£15 – £5) x £10 = £10 x £10 = £100

Consumer Tax = (£15 – £10) x £10 = £5 x £10 = £50

Producer Tax = (£10 – £5) x £10 = £5 x £10 = £50

Ad-valorem Tax

  • An ad-valorem tax is charged as a percentage of the price of a good. E.g. VAT is 20% in the U.K. & air passenger duty 
  • If a restaurant meal costs £100. The VAT on this meal would be £20 and the total price of this meal would therefore be £120.
  • As this is a percentage tax if the meal costs £200 instead. The VAT amount would be £40. Therefore the tax (VAT) increases with the price of the good or service.
  • An ad-valorem tax always causes a pivotal rotation of the supply curve to the left as shown below.

 

 

 

Calculating the tax area:

Whole Tax = (£18 – £7) x £10 = £11 x £10 = £110

Consumer Tax = (£18 – £10) x £10 = £8 x £10 = £80

Producer Tax = (£10 – £7) x £10 = £3 x £10 = £30

 

 

 

 

Quick Fire Quiz – Knowledge Check

1. State the two types of taxes (2 marks)

2. Explain the impact of taxes imposed (2 marks)

3. Distinguish between a direct tax and an indirect tax (4 marks)

4. Identify two examples of a direct tax (2 marks)

5. Identify two examples of an indirect tax (2 marks)

6. Using a diagram, explain the effects of a ‘specific indirect tax’ imposed. In your explanation, please refer to an example. (6 marks)

7. Using a diagram, explain the effects of a ‘ad valorem indirect tax’ imposed. In your explanation, please refer to an example. (6 marks)

 

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