GCE Economics 2022 Theory — Question 6

Model answer

(a)(i) Specific tax: this is a type of indirect tax that is imposed or levied according to the volume or units of goods imported, exported or manufactured locally. It is a type of tax levied at a fixed rate per unit of output. (ii) Value-added tax (VAT): this is a type of indirect tax that is levied/imposed by the government at different stages of production of a good or service. (b) Indirect taxes are taxes imposed or levied on goods and services; they have significant effects on demand and supply. Generally, the higher the indirect tax on a commodity, the higher the price of the commodity, and the lower the quantity demanded, and vice versa. (i) Perfectly Inelastic Demand: demand is said to be perfectly inelastic when the quantity demanded does not react to changes in the price of the commodity (i.e. the quantity demanded remains the same regardless of whether the price rises or falls). However, an indirect tax charged/imposed on a commodity with this type of elasticity of demand will increase the price of the commodity by the entire amount of the tax, because buyers do not react to any change in the price of the commodity. This means the entire burden of the indirect tax is shifted onto the buyers alone, i.e. new price P2 = old price P1 + tax. DIAGRAM: the supply curve shifts upward/leftward from S1 to S2 by the amount of the tax; the demand curve is vertical; the shaded area between P1 and P2 (up to the vertical demand curve) represents the tax, entirely borne by the buyer, with quantity demanded unchanged at Q1. (ii) Perfectly Elastic Demand: demand is said to be perfectly elastic when the quantity demanded is highly sensitive/reacting to any change in the price of the commodity. However, an indirect tax charged on a commodity with this elasticity of demand will have NO effect on the price of the commodity, because buyers react sharply to any slight change in price. Therefore, the sellers alone bear the burden of the tax imposed, and this will reduce the quantity supplied (from Oq1 to Oq2), while the price of the commodity remains unchanged at OP1. DIAGRAM: the demand curve is horizontal at price P1; the supply curve shifts upward from S1 to S2 by the amount of the tax; the shaded region represents the indirect tax, entirely borne by the sellers, since the price remains at OP1 while quantity supplied falls from Oq1 to Oq2.