Research Assignment IB Economy IA: Tax Incidence and PED

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IB Economy IA
A major tax shake-up in form of Value Added Tax (VAT) reforms implemented by the Chinese government is expected to stimulate economic growth. One of the companies that has already benefited is GZL, a travel agency, which has saved approximately 3.65 million yuan ($535,700) in payment of VAT since the policy was implemented in May 2016 (Yanfei). In the first quarter of 2017, the firm’s overseas market increased by close to 30% because of VAT revenues that were saved.
Tax incidence and PED
When the government imposes a tax on a good, both the consumer and the producer pay part of the tax. When the price elasticity of demand (PED) is relatively inelastic, consumers will have to pay more to purchase a product after taxation of the product (Pc
1170940857250533400200025Q1producersQ1producers2314575132715S2=S1+tax00S2=S1+tax-1524001171575P00P11906252619375Quantity (Q)00Quantity (Q)5715001047750consumers00consumers104775800100Pc00Pc1047751304925P*00P*1809751600200Pp00Pp2076450504825Tax @unit00Tax @unit2847975600075S100S119145252362200Q*0Q*504825163830053340013811251019174704850504825200025
Fig 1: Relative inelastic PED
However, in this case, the Chinese government decided to reduce exempt businesses from VAT implying that the price of goods goes down. This implies that businesses can retain the money they used to pay as VAT and therefore, the goods will be more affordable to consumers. The issue of tax exemption can be analyzed from different perspectives. Multi-rate VAT systems are often adopted by different countries where reduced tax rates are applied to one or more goods (Ortiz-Ospina and Roser). In the case described in this article, the VAT system that was applied by the Chinese government when it exempted overseas business activities of locally based companies (Yanfei). VAT exemptions allow businesses to reduce their cost of operation and thus motivate consumers to purchase more goods, which ultimately leads to spillover effect that promotes economic growth.
111442577470375285077470S2=S1+ tax00S2=S1+ tax
4429125231775S100S1
3238500100330tax00tax
1190625302260c00c71755216535P00P676275216535Pc00Pc
676275189865P*00P*199072588891114425294640
1190625106045P00P4429125248920D00D
67183031750Pp00Pp
285750035560Q*00Q*187642554610Q100Q1
240982427940Quantity (Q)00Quantity (Q)
Fig 2: Relative elastic PED
Figure 2 above shows the effect of a tax on a supply curve when the price elasticity of demand of a product is relatively elastic. In both figure 1 and 2, the supply curve moves from S1 to S2 after taxation and the new equilibrium becomes QtPc. Therefore, the shaded region in both diagrams indicates the amount of tax that is paid to the government, and it is calculated by (Pc –Pp) x Qt. Therefore, the tax burden (incidence for consumers is (Pc – P*) x Qt. In the case of China, the government decided to exempt certain companies and this implies implies that they are removed from this tax burden.
In the article, Premier Li Keqiang said that the aim of VAT reform was to reduce the tax burden that businesses are subjected to and thus act as an impetus of transforming the economy and e...