VAT Theories - Indirect Tax - What happens to market prices?

There are two main types of indirect tax - a per-unit tax and an ad-valorem tax. A per-unit tax is one where the amount charged is always the same on each unit. Examples of these in the UK are the duties on alcohol and cigarettes. An ad-valorem tax, by contrast is one where the tax is charged as a percentage of the value of the good. This is where VAT comes in, as it is always 17.5% of the value of the good.

The effect on the market equilibrium will be slightly different for each of these two types of tax. Let's look first at the per-unit tax. This sort of tax will be paid over to the government by the firm and will therefore shift the firm's supply curve. To be willing to supply the same quantity as before, it will now want the price to be higher by the amount of the tax. The tax has therefore shifted the supply curve vertically upwards by the amount of the tax. The impact of this on the market is shown below:

As you can see from the diagram, the equilibrium price has risen and the equilibrium quantity has fallen. The extent to which this happens depends on the elasticity of demand for the good or service. There is more detail on this further on in this theory section. Click on T3 below to access it.

For an ad-valorem tax, the principles are the same but the effects very slightly different. The tax will still shift the supply curve vertically upwards as the firm will want a higher price to compensate it to supply the same quantity. However, because the tax is a percentage of the value of the good, it will shift by different amounts according to the price of the good. For example, the VAT on a good costing £10 will be £1.75, but for a good costing £100 it will be £17.50. The effect of this on the supply curve is shown in the diagram below:

The impact on the equilibrium price and quantity therefore depends on the amount of the tax and the original price level. The elasticity of demand will also be important - for more details on this try looking at T3 below.