Tradeoffs Involved in Indirect Taxation

Economics is all about trade-offs. The government too, faces such tradeoffs while coming out with any economic or financial policy. Such is the case while deciding indirect taxes. This article has been written with the intention of analyzing the effects of indirect taxation on the market equilibrium, which leads to the analysis of constraints on the government while deciding taxes.

The objective of indirect taxation (or any form of taxation for that matter) is to maximize the revenue generated for the government. In that context, high tax rates would be ideal. But as we shall see very high tax rates are also undesirable, as they tend to stifle economic growth, as well as contribute to inflation. Hence the government is caught in a balancing act, where it needs to trade-off revenue generation in the favour of economic growth.

(The analysis has been made keeping in mind the Indian scenario. This includes underlying assumptions of a democratic setup, a significantly large poor and lower middle class vote-banks, and a rapidly growing economy.)


Effect of Indirect taxes on Market Equilibrium:

In a market with no indirect taxes, at equilibrium, the price paid by the consumer is the same as the price obtained by the seller. If Ps is the price obtained by the seller, and Pc is the price paid by the consumer, then Ps=Pc. Qe is the equilibrium quantity.

An introduction of indirect taxes causes a change in equilibrium. Now Ps is no longer the same as Pc. Rather Pc > Ps, by an amount t, which is the tax paid to the government, i.e. Pc = Ps + t. Also, there is a reduction in the equilibrium quantity, from Qe to Q* as shown in the diagram below.

From the above diagram, the following conclusions are drawn:
i. The Consumer ends up paying a higher price. If the demand is relatively elastic, there is less incidence of the tax on the consumer, but if the demand is relatively inelastic, the consumer bears the major brunt of the tax.
ii. The Seller gets a lower price. In case of an inelastic demand, the seller can pass of a major brunt of the tax to the consumer, but in a relatively elastic demand, the seller has to bear the major brunt.
iii. There is a reduction in the quantity consumed at equilibrium. The more inelastic the demand, the lesser is the reduction in consumption. The greater the tax amount, the higher the fall in consumption.
iv. The difference between Pc and Ps is the tax that goes to the government. In order to maximize tax revenues, items with relatively inelastic demands, i.e. necessities should be taxed.


Revenue maximization and Constraints

In order to maximize its tax revenues, the government can either impose high taxes on non-necessary (luxury) items, or impose taxes on necessities, so as to minimize any tax loss due to fall in consumption. However, both options are subject to severe constraints.

A high rate of taxation leads to a fall in consumption. Any fall in consumption leads to a slowdown in the production of that particular good. In addition, the rise in price for the consumer leaves him with lesser disposal income to spend, which in turn will cause a further fall in consumption. Hence, a high rate of taxation on too many goods may lead to a general industrial slowdown. This is not desirable for the government, as the government does not wish for a recession in the industry, which will bring down the growth rate of the economy in general.

(Although this may not always be true. In an ideal scenario, the government is the biggest spender, and the revenues collected by it will be pumped back into the economy. This will again give an impetus to the industry. A recession on higher incidence of tax hence, is not a certainty. But in the Indian context, due to the leakage in the system, and on account of a significant proportion of defence expenditure, a relatively smaller percentage of the revenue makes it back to the national economy.)

Similarly, imposing taxes on necessities has its own political connotations. Also, the tax burden in case of necessities can be almost entirely passed on to the consumer. As the consumer cannot run away from necessities, the rich and the poor are equally affected by indirect taxation. The price rise of necessary goods causes an increase in inflation, which has always been a politically sensitive issue. Any government wishing for public good will does not want a rise in inflation.

Thus the government is severely constrained in terms of ways to generate revenue from indirect taxation. Any government looking for a healthy growth rate will always keep tax rates moderate, while looking for other sources of revenue. Political pressures also keep governments from taxing necessities, especially in a country where the price of onions decides the future of the government.