Ad Valorem Tax on Salt

Posted by: Evangel on: November 17, 2010

• In: Notes | Section 2: Microeconomics
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A tax is a compulsory contribution to state revenue, levied by the government on workers’ income and business profits or added to the cost of some goods, services, and transactions. There are two types of indirect tax, one being ad valorem tax. Ad valorem tax is a tax that is levied as a percentage of the selling price. This means that at low prices the tax will be relatively little, but at higher prices the tax levied will be higher. An inelastic demand is not very responsive to the changes in price of a product. In other words, even when the price rises, most of the consumers will still purchase the products.

(Figure 1) Incidence of an ad valorem indirect tax placed on salt

When an ad valorem tax is added on to a good which has relatively inelastic demand, such as salt, the consumers pay larger amount of tax than do the producers. When an ad valorem tax is place on salt, the supply curve shifts from S₁ to S₂, moving the equilibrium point from E₁ to E₂. Because tax is placed, the price of salt rises from P₁ to P₂. Even when the price rise significantly, the quantity demanded does not change dramatically; it moves from Q₁ to Q₂. Now, with the tax, salt is sold at the price of P₂ and is demanded by Q₂ amount of people. The government receives the total amount of P_X X E₂ P₂. Out of this amount, producers pays relatively less than the consumers. Since salt is an inelastic demand, consumers purchase it even the price rises. Therefore, the producers pass on most of the responsibility of paying tax to the consumers; in figure 1, consumers pay approximately three times more tax than the producers.

Tags: Ad valorem tax, Burden, Consumers, Demand, Elasticity, Government, Incident, Inelastic, Price, Producers, Salt, Supply, Tax