Implications of Ad Valorem Taxes, Compared to Unit Taxes

By Revanza Almaas, a Directorate General of Taxes officer

An ad valorem tax is a tax based on the assessed value of a tax object, such as property, assets, services, and goods. It is seen as a percentage. The Latin phrase ad valorem means "according to value". All ad valorem taxes are collected according to the determined value of the taxed item. In the most common application of ad valorem taxes, namely property taxes (pajak bumi dan bangunan), public tax appraisers regularly assess the property owner's real estate in order to determine its current value. Then, the determined value of the property is used to calculate the tax owed. An ad valorem tax is not limited to property and may extend to other kinds of taxes.

1. Property Tax
   Property tax is an ad valorem tax that the owners of real estate (commercial and residential properties), plantations, forestry, mining, or others pay on the value of their property. A tax appraiser may come to determine the value of the property before arriving at the tax assessment value. According to Law Number 1 of 2022 Concerning the Financial Relation between Central Government and Local Government, article 41, the property tax rate of rural and urban sectors is set at a maximum of 0.5 percent. Meanwhile, the property tax rate of the other remaining sectors is a single rate of 0.5 percent (Law Number 12 of 1985 Concerning Property Taxes).
2. Value-Added Tax
   A value-added tax is a tax charged on a value added by a business on the goods and services it purchases from the market. It is an indirect tax that is collected from a different party than the one who bears the cost of the tax. VAT has a single tax rate of 11 percent. This rate of ad valorem tax is levied on every stage of production, with the manufacturer and retailer both paying VAT at their respective stages.
3. Real Estate Transfer Tax
   When a real estate is sold, the deed to that real estate is transferred from one owner to another. A real estate transfer tax is a charge levied on that transfer of ownership or title to property from one individual or entity to another. The party responsible for paying this transfer tax is the seller. This tax has varying rates, ranging from zero to 2.5 percent, depending on the type of the property transferred.

Some local taxes are ad valorem taxes, too. One example is restaurant taxes, since the rate is also a proportion of the price/value. Because ad valorem taxes are computed as a percentage of the value, the tax owed is fluctuating according to value. This is the opposite of unit taxes, or some people call it specific taxes.

Unit Tax

A unit tax is a fixed tax on a product; it is levied as a fixed amount per unit of commodity purchased. The unit can be a kilogram, a liter, a gram, etc. The tax calculation, therefore, is proportional to the particular quantity of a product and is independent of the product's price. This kind of tax has administrative advantages when it is easy to measure quantities of the product or service being sold. In Indonesia, the majority of unit taxes are present in the form of excise, such as sugar-sweetened beverages excise tax, cigarettes excise tax, and alcoholic beverages excise tax. An example is the imposition of an excise of IDR13,200 on ethyl-alcohol with a 5 to 10 percent alcohol content. 

From various sources

In the unit tax scenario, the imposition of a unit tax will make a parallel shift in the curve. P0 and Q0 are the price and quantity demanded before the imposition of a tax, respectively. Then, suppose that a carbon tax of IDR30 per kilogram of carbon dioxide is imposed on manufacturers. It comes as no surprise that the manufacturers then move the tax burden to the consumers. After the tax, the manufacturers still want to receive P0 per unit and the consumers must pay price (P0+t) per unit. Unfortunately, the manufacturers can't maintain the price at P0, since the quantity of consumers demanding the new price (P0+t) has shrunk. The supply curve perceived by consumers is shifted up by the amount of the tax. The posttax equilibrium is Q1, where S1 and D curves intersect. Tax revenues that the government collects are the number of unit purchased times the tax per unit. This is geometrically shown as a rectangle below Pc and above Pp.

Ad Valorem Tax

As opposed to a unit tax, an ad valorem tax is a tax with a rate given as a proportion of the price or value. The analysis of ad valorem taxes is very similar to that of unit taxes. There is just a little difference: instead of moving the supply curve up by the absolute amount of each quantity, the ad valorem tax raises it by the same proportion.

From various sources

To show this, let's take P0 and Q0 as the price and quantity demanded before the imposition of a tax, respectively. Then, suppose that a real estate transfer tax of 2.5 percent is levied on properties sold by general contractors (sellers). After the tax, the contractors still want to receive P0 per unit and the consumers must pay price (P0+t) per unit. Unfortunately, the supply curve (perceived by consumers) has shifted upwards, creating a new equilibrium where S1 and D intersect. Despite the same price the contractors offer, consumers only see the final price that they must pay, i.e., the original price plus t (2.5 percent of that original price). The amount of t varies depending on the price itself. The more expensive a property, the greater the tax burden. The supply curve then makes a pivotal shift. This pivotal shift changes the slope of the curve.

Ad valorem taxes affect the price less directly than unit taxes, raising the price by proportion. Unit taxes move the supply curve without altering the shape and slope, while ad valorem taxes make a pivotal shift and change the slope of the curve. This change in slope makes the new supply curve have weaker elasticity. 

Understanding the differences between ad valorem and unit taxes is crucial for informed policy decisions and individual financial planning. While both generate revenue for the government, their impacts on prices, consumer behavior, and administrative complexity vary significantly. Ad valorem taxes, with their sensitivity to value fluctuations, can offer progressive revenue generation but might be administratively challenging. Unit taxes, with their fixed per-unit charges, simplify administration but have less flexibility in capturing revenue and can potentially impact lower-income individuals disproportionately. Ultimately, the optimal tax structure depends on specific policy goals, economic conditions, and administrative feasibility. As individuals, being aware of these different tax types helps us understand the impact they have on our finances and engage in informed discussions about public policy choices.

*) This article is the author's personal opinion and does not reflect the attitude of the agency where the author works.

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