Indirect taxation and subsidies

• What is indirect tax?

  • An indirect tax is an expenditure tax that is paid when goods and services are purchased
  • Indirect taxes are levied by the government to solve market failure and/or to raise government revenue
  • Government revenue is used to fund government provision of goods/services e.g education
• Who do governments levy indirect taxes onto?

  • Indirect taxes are levied by the government on producers, increasing the cost of production for firms
  • Costs can be transferred on to consumers via higher prices
  • Higher prices reduce quantity demanded (QD) and discourage the consumption of specific goods or services, for example demerit goods or products that generate negative externalities
• What does this diagram show?

  • The initial equilibrium is at P1Q1
  • The government places a specific tax on a demerit good
  • The supply curve shifts upward from S1→S2 by the amount of the tax
  • The new equilibrium is at P2Q2
  • The price the consumer pays has increased from P1 to P2
  • The price the producer has received has decreased from P1 to P3
  • The consumer incidence of tax is equal to Area A (P2-P1)xQ2
  • The producer incidence of tax is equal to Area B ((P1-P3)xQ2
  • The final price is lower and the QD is higher, resulting in a deadweight loss to society

  
• What are the advantages of indirect taxes?

  • Raises the price and reduces the quantity demanded of demerit goods
  • Reduces external costs of consumption and production
  • Raises revenue for government programs
• What are the disadvantages of indirect taxes?

  • The effectiveness of the tax in reducing the use of demerit goods depends on the price elasticity of demand (PED)
  • Indirect taxes are often placed on price inelastic goods so QD may not fall very much
  • It may lead to the creation of illegal markets as consumers seek to avoid paying the taxes
  • Producers may be forced to lay off some workers as QD and output falls due to the higher prices
• What is a producer subsidy?

  • A producer subsidy is a per unit amount of money given to a firm by the government
• Why are subsidies used by governments?

  Subsidies are used by governments to solve market failure by attempting to increase the output and consumption of specific goods or services, for example, merit goods
• What do subsidies do?

  • A subsidy reduces the costs of production and encourages an increase in the output of a good or service
• What do producers do with a subsidy?

  • Producers keep some of the subsidy and pass the rest on to consumers in the form of lower prices
  • Lower prices of a product encourage increased consumption
• What is the distribution of subsidy between producers and consumers is determined by ?

  • The distribution of the subsidy between producers and consumers is determined by the price elasticity of demand (PED) of the product
• What does this diagram show about the impact of subsidy?

  original equilibrium - P1Q1

  • subsidy supply curve from S → S + subsidy
  • increases the QD in the market from Q1 → Q2
  • new market equilibrium - P2Q2
  • lower price and higher QD in the market
  • Producers receive P2 from the consumer PLUS the subsidy per unit from the government
  • Producer revenue is therefore P3 x Q2
  • Producer share of the subsidy is marked B in the diagram
  • The subsidy decreases the price that consumers pay from P1 → P2
  • The total cost to the government of the subsidy is (P3 - P2) x Q2

  
• What are some advantages of subsidies?

  • A subsidy increases demand for merit goods
  • It lowers prices make goods more affordable to those on lower incomes reducing effects of poverty
  • Can be targeted to helping specific domestic industries
  • Helps to change destructive consumer behaviour over a longer period of time e.g. subsidising electric cars makes them affordable and helps motorists to see them as an option for the masses, not just the wealthy
  • Can be used to help domestic firms compete internationally
• What are some disadvantages of subsidies?

  • It distorts the allocation of resources in markets
  • E.g. it often results in excess supply when used in agricultural markets
  • There is an opportunity cost associated with the government expenditure
  • Subsidies are a disincentive for firms to become more efficient or competitive
  • Subsidies are prone to political pressure and lobbying by powerful business interests
  • E.g most oil companies receive subsidies from their respective governments (despite making substantial profits each year)