IB economics - indirect taxes

Why are they a cost of production?

This is Luca. Luca wants to climb the Kilimanjaro. He got his backpack and he is all ready to start the climb. However, when he arrives to the mountain he is told that the government forces all hikers to hire a local guide.

He suddenly meets a local guide, Bruno. Bruno is more than happy to help Luca climb the Kilimanjaro and he agrees to charge $20 for the service.

They start going towards the mountain. But, oh the horror!

pum put put put put this girl here, Kim, is a government official. She has decided to set a new tax. all the tourists that go up the kilimanjaro, now have to pay a fee of 500 dollars, which is collected when they pay for their trip.

Let’s go back to Bruno and Luca. What should they do? Bruno has a dilemma. If he only charges the agreed 20 dollars, but he has to pay 500 dollars to Kim in the indirect tax, then Bruno would be losing 480 dollars. Bruno realises that the minimum he can charge to Luca for a climb to Kilimanjaro in order to make a profit from the trip, is the 500 dollars in tax. Anything else than that would generate a loss for Bruno.

This is why indirect taxes are considered as a cost of production for firms: an increase or an introduction of an indirect tax, in practice means that the firm has to charge a higher price to its consumers. It would be the same as if the cost of raw materials had increased, or the cost of wages had gone up, and it is represented by an inwards shift of the supply curve.

Bruno agrees to charge to Luca 510 instead of the 500 dollars in tax + the original 20 dollars of the agreed service. Why not passing the full tax onto Luca? this depends on the relative elasticities of demand and supply, which will be covered in another video.

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