Application of Indifference Curve on Tax
To design an appropriate tax rate, an indifference curve may be useful. An important area in which the indifference curve technique has been applied of making choice between direct and indirect taxes. Policymakers are often faced with the question, whether it will be better to levy a direct tax or an indirect tax from the viewpoint of the welfare of the individuals. The conclusion is derived with the help of the below figure:
In the above figure, units of X are measured along the X-axis and the money income of the consumer is measured along Y-axis respectively. Initially, the consumer is at equilibrium at point E1, where the budget line AB is tangent at point E1 where the consumer consumes OX1 units of X by spending AM units of money income. When the government imposes an indirect tax then the price of X good increases as a result, the purchasing capacity of consumers decreases, and the budget line rotate leftward at AB1, which is tangent to IC2. It shows that the welfare of the consumer has declined. Likewise, when the government imposes a direct tax on individuals. This reduces the money income of the consumer. So, the budget line shift towards the left at A1B2, which is parallel to AB, and passes through point E2. The budget line passing through E2 indicates that the consumer pays income tax equivalent to excise duty paid through indirect tax but he moves on higher indifference curve IC3. From the above analysis, it has been proved that direct tax reduces the individual’s welfare less than that of an indirect tax. Here, the indifference curve plays an important tool while making a discussion.