The impact and incidence of ad valorem taxes - YouTube

In this video we will take a look at the impact of an ad valorem tax for products that have

elastic and inelastic demand.

We will then analyse the incidence of that tax and finally look at the overall effect

on the efficiency of the market.

With this market in equilibrium, we establish our starting point for analysis.

Suppose the government introduces an ad valorem tax, such as a 20% VAT, thereby increasing

the costs of production for firms.

As they are paying a percentage tax for the value of products sold, the new supply curve

rises at a sharper incline than the initial supply curve at higher quantities.

The distance between the two supply curves is the value of our tax.

To understand why the distance grows bigger with an ad valorem tax, consider the difference

between $1 and 20% of $1.

The distance is not much, about 20 cents.

However, if you sell $10,000 worth of goods, 20% is a much more significant difference,

about $2,000.

As the value of goods rises, so does the value of the tax.

After the tax has been imposed, we can see the supply curve shifts leftward.

The new, higher market price is Pc and the new, lower market quantity is Q1.

Therefore the impact of an ad valorem tax on a product with elastic demand is to reduce

equilibrium quantity and raise price.

However, it is important to note that the impact on price and quantity depends on the

elasticity of demand for the product as we’ll see in the next slide.

A product with inelastic demand would see its price rise sharply, but with little corresponding

reduction in quantity.

If the demand curve were perfectly inelastic, the price of the good would rise by the full

value of the tax but there would be no change in equilibrium quantity.

This is the part where it often gets tricky for students, so I’ve tried to break it

down into manageable chunks.

If you have difficulty, slow down the video, pause it and review the parts where you are

unclear.

We’re going to see the incidence, or burden, of tax.

We’ve already established that the price consumers pay is Pc.

You’ll note that the difference between the supply curves is the value of the tax,

but the price increase from equilibrium to Pc is not equal to the entire amount of the

tax.

At Pc, there are Q1 units produced.

At output of Q1, the ad valorem tax is represented by the distance between the supply curves.

Therefore after the tax is deducted from the price paid by the consumer, we have the price

received by the seller, Ps.

The value of the tax is the difference between Pc and Ps.

Now we are able to determine the burden of taxation taken on by consumers and producers.

The portion that is taken up by producers is the area below the initial equilibrium

price and above the price received by sellers.

It is bordered by Q1.

The burden on consumers is equal to the amount they are paying above the initial equilibrium

price times the quantity sold of Q1, represented on the graph in green.

The total tax revenue received by the government is the area including both the consumer and

producer burden.

It can be calculated by multiplying Q1 * (Pc-Ps).

The consumer surplus is represented by the area above the price paid by consumers and

below the demand curve.

It has clearly been reduced by the imposition of the tax.

The producer surplus is represented by the area above the supply curve and below the

price that sellers receive.

It has also clearly been reduced by the tax.

The green and red portion represent the revenue taken by the government, but we still have

an unaccounted for region, represented by the blue triangle on the right.

This area represents our deadweight loss.

If the market was functioning without any tax, it would clear at equilibrium.

Consumers and producers still enjoy some surplus, and the government collects revenue.

The blue triangle represents a reduction in the overall welfare of society, since no party

can enjoy the benefit, resulting in deadweight loss.

Alright, I hope you’re still with me and are feeling more comfortable with the concept

of an ad valorem tax, its impact and incidence.

This is a tough topic and one that many AS students struggle with.

I hope I’ve been able to shed some light on the subject and help you understand it

better.

Stick with me as we continue to work through the rest of the CIE syllabus and you should

start to feel more confident with these concepts as you see them throughout the course.

As always, feel free to contact me at [email protected] or tweet me @EnhanceTuition.

Leave a comment below if there’s anything in particular I can help you with.