1.2.9 Indirect taxes and subsidies

• Indirect taxes


  Taxes imposed by the government that increase production costs for producers
• Indirect taxes increase production costs for producers


  Producers supply less
• Producers supplying less


  Increases market price and demand contracts
• Types of indirect taxes

  • Ad valorem taxes (e.g. VAT)
  • Specific taxes (e.g. fuel duty)
• Ad valorem taxes


  Percentages, such as VAT, which adds 20% of the unit price
• Specific taxes


  A set tax per unit, such as the 58p per litre fuel duty on unleaded petrol
• Diagrammatically, indirect taxes are shown by the vertical distance between two supply curves
• When demand is perfectly inelastic, or supply is perfectly elastic


  The incidence of the tax falls wholly on the consumer
• If demand is more elastic (PED>1)


  The incidence of the tax will fall mainly on the supplier
• If demand is more inelastic (PED<1)


  The incidence of the tax will fall mainly on the consumer
• Ad valorem taxes


  The absolute value of the tax increases as the price of the good increases, causing the supply curve to pivot
• If demand is inelastic


  Government revenue from the tax is higher than if demand is elastic
• The duty on tobacco and fuel raises a lot of government revenue, because demand for these goods is inelastic
• If the tax is implemented with the intention of internalising the externality, it is hard to put a monetary value on the externality
• Internalising the externality means the individual or firm which causes the negative externality, for example pollution, pays for the damage
• Taxes could be expensive for the government to collect
• Some taxes could be regressive, so they impact those on low and fixed incomes the most
• Taxes could be inflationary
• Subsidy


  A payment from the government to a producer to lower their costs of production and encourage them to produce more
• Subsidies shift the supply curve to the right


  Lowering the market price
• The vertical distance between the supply curves shows the value of the subsidy per unit
• Effects of subsidies


  • Increase output and lower prices for consumers
  • Increase the employment rate
  • Reduce inequality in society
  • Help control inflation
  • Boost demand during periods of economic decline
  • Encourage the consumption of merit goods
  • Increase long run aggregate supply
• There could be government failure, if the government provides an inefficient subsidy or if the subsidy distorts the market price
• Government revenue could be better spent elsewhere. The opportunity cost of the subsidy should be considered
• It is usually the tax payer who pays for the subsidy, and they might not receive any direct benefit from the subsidy
• If demand is price inelastic


  The subsidy will have a large effect on equilibrium price, giving a greater consumer gain than when demand is elastic
• If demand is price elastic

  The subsidy will have a large effect on quantity, and therefore benefit producers more
• Consumer subsidy


  Encourages consumers to purchase more of a particular good or service, affecting demand but not shifting the supply curve
• Producer subsidy


  Lowers the cost of production and shifts the supply curve