(a) What is a specific tax? (2 marks) (b) Explain with the aid of diagrams, the effects of specific tax on a commodity that has a: (i) perfectly elastic dem...

Answer Details

(a) Specific tax. A specific tax is an indirect tax levied as a fixed amount of money per unit of a commodity (for example \$2 per kilogram), regardless of the price of the good. It shifts the supply curve vertically upward by the amount of the tax.

(b) Effects of a specific tax on incidence, by elasticity of demand. The incidence (burden) of the tax is shared between producer and consumer according to the relative elasticities of demand and supply.

(b)(i) Perfectly elastic demand. The demand curve is horizontal, so the consumer will not pay any price above the ruling market price. When the tax shifts supply up, the price to the consumer cannot rise. Therefore the whole burden of the tax falls on the producer; the market price stays the same and the quantity sold falls sharply. On the diagram, draw a horizontal demand curve; the supply curve shifts up by the tax, quantity falls, but the price paid by consumers is unchanged.

(b)(ii) Perfectly inelastic demand. The demand curve is vertical, so the same quantity is bought whatever the price. When supply shifts up by the tax, the price rises by the full amount of the tax and quantity is unchanged. Therefore the whole burden falls on the consumer. On the diagram, draw a vertical demand curve; the supply curve shifts up by the tax, the price rises by exactly the tax, and quantity is unchanged.

(c) Two differences between direct tax and indirect tax.

Examination takeaway. The general rule of tax incidence is that the burden falls more heavily on the side of the market that is less elastic; the two extreme cases here (perfectly elastic and perfectly inelastic demand) show the burden falling entirely on the producer and entirely on the consumer respectively.