1.2.9 Indirect taxes and subsidies

• inderect tax is tax on goods/services by government
• types of indirect tax: Ad valorem tax and specific tax
• specific tax is a fixed amount of tax per unit of a good, regardless of its price.
• Ad valorem tax is a tax calculated as a percentage of the value of a good or service.
• incidence of tax is the tax burden on the taxpayer
• if the demand curve is perfectly elastic or supply curve is perfectly inelastic the supplier will pay all tax
• • If the demand curve is perfectly inelastic, or the supply curve is perfectly elastic, all the tax will be passed on to the consumer.
• • the more elastic the demand curve, or the more inelastic the supply curve, the lower the incidence of tax on the consumer, meaning the supplier has to pay more.
• what is a subsidy?

  a grant given by government to encourage production/consumption of a good or a service
• subsidies may be imposed on neccesites to encourage consumptiona ad reduce cost of production
• Subsidy diagram

  subsidy diagram

  
• Chain of Analysis: Opportunity Cost of Subsidies

  1. Subsidy Allocation: The government allocates funds to subsidize certain goods.
  2. Opportunity Cost: The funds used for subsidies could have been spent on other public services, such as healthcare or infrastructure.
  3. Risk of Inefficiency: Subsidies may be provided for goods that do not significantly improve welfare (e.g., poorly targeted subsidies).
  4. Outcome: Misallocation of resources can result in inefficiencies and reduced overall welfare.
• Chain of Analysis: Correcting Market Failure with Indirect Taxes

  1. Market Failure Identified: The consumption of a good, such as cigarettes, generates negative externalities (e.g., health costs).
  2. Tax Imposed: The government imposes an indirect tax to internalize the externality, raising the price.
  3. Behavioral Change: Higher prices discourage consumption, reducing the negative externality.
  4. Outcome:

  • Market output decreases to the socially optimal level.
  • Tax revenue can be used to fund healthcare or other public services.
  • However, the tax may disproportionately affect low-income households.
• How do subsidies correct market failure?

  Subsidies encourage the production and consumption of goods with positive externalities (e.g., education, healthcare) by lowering costs and increasing affordability.
• How do indirect taxes correct market failure?

  Indirect taxes can internalize negative externalities (e.g., pollution) by increasing the price of harmful goods, reducing their consumption and production.
• What is the impact of subsidies on government spending?

  Subsidies increase government spending and can lead to opportunity costs if funds are diverted from other areas of public expenditure.
• Who benefits more from a subsidy if demand is inelastic?

  Consumers benefit more from a subsidy if demand is inelastic because the lower price significantly increases consumer surplus.
• Who bears more of the tax burden if demand is inelastic?

  Consumers bear a larger share of the tax burden if demand is inelastic because they are less responsive to price changes.
• What is the incidence of tax?

  The incidence of tax refers to how the burden of a tax is shared between producers and consumers, depending on the price elasticity of demand and supply.
• How does a subsidy affect supply?

  A subsidy shifts the supply curve vertically downwards, reducing prices and increasing the quantity demanded.
• How does an ad valorem tax affect supply?

  An ad valorem tax shifts the supply curve upwards at an increasing rate, as the tax rises with the price of the good.