Using an appropriate diagram, explain how an indirect tax can change the free market price and the allocation of resources. This is an economics question.

Expert Answers
pohnpei397 eNotes educator| Certified Educator

An indirect tax is one such as a sales tax or a value-added tax as opposed to one that is levied directly on your income or your property.

What this sort of tax does is to move the supply curve to the left (lowering supply).  It does this because it makes suppliers want to charge a higher price for a good (because they have to give some of their receipts to the government).

Whenever the supply curve moves to the left, two things happen -- the price goes up (above the free market price) and the quantity bought/sold goes down.

So -- an indirect tax increases the equilibrium price and causes underallocation of resources because fewer of the item in question are bought/sold than "should have" been the case without the tax.

See the link for diagrams.

krishna-agrawala | Student

Indirect tax refer to the taxes that are levied on sale purchase and manufacture of goods and services. These include taxes such as sales tax, value added tax, and excise duty. These taxes are called indirect taxes because, unlike income tax and wealth tax, these are not based on individual income or wealth.

The indirect taxes may be payable by either buyer of a good, or the seller or manufacturer of the goods. When tax is paid by the seller it has the impact of increasing the price of goods paid by the buyers, without corresponding increase in price realized by the seller.This in turn results in shift of the demand curve to the left in terms of prices without tax.

Similarly when indirect taxes are paid by sellers they increase the cost of the seller. The sellers have the option of increasing the price of the goods sold by them to fully cover the taxes paid by them. However, the exact increase in price will depend on shift in supply, which in terms of cost without the tax will shift to right.

Because of these shifts in demand and supply curves the market equilibrium prices and quantities will change also. In general higher the rate of tax lower will be the the equilibrium price without tax. However the equilibrium price including tax is likely to be higher, and because of that the quantity sold and consumed is likely to be lower.

IN terms of market allocation of resources, the indirect taxes tend to draw resources away from the goods taxed at higher levels to the goods taxed at lower levels. Also when there is significant differences in types of goods consumed by different sections of society, the indirect taxes have the impact of reducing the effective income of people consume the goods taxed. In this way there is indirect taxes impact also the distribution of resources and income between different sections of society.