1.2.9/10 Indirect taxes and subsidies & Alternative views of consumer behaviour

What is the purpose of indirect taxes?

Purpose of indirect taxes

• increase govt. revenue (e.g VAT)

• solve market failures// reduce consumption/ production of goods that are harmful to society (e.g cigarette duty, alcohol duty, fuel duty)

What are direct taxes?

Direct taxes= taxes on income that cannot be transferred (e.g income tax, national insurance, corporation tax)

What are indirect taxes?

Indirect taxes= expenditure taxes added to goods and services sold. They increase production costs for firms but can be passed onto consumers via higher prices

What are 2 e.g of indirect taxes?

2 e.g of indirect taxes=

• specific tax

• Ad valorem tax

What is specific tax?

Specific tax= a fixed tax amount per unit of a good. The tax increases with the amount bought now value of good.

• supply curve shift= shifts parallel upwards from S₁ to S_{1 and tax.}

• the vertical distance represents between the 2 supply curves represent the constant tax per unit.

What is Ad valorem tax?

Ad valorem tax= a tax as a % of the price of a good. The tax payable increases increases in proportion to the value of the good

• supply curve shift: pivoted upwards from S₁ to S_{1 and tax}

• the vertical distance (tax value) increases as the price increases

What happens to the ad valorem tax when the price is small?

When the price is small, the tax will only be a small amount but when the price is high, the tax will be a large amount. The distance grows as the tax grows.

What is the impact of indirect taxes on consumers?

Impact of indirect taxes on consumers=

• higher prices (P2) and lower quantity consumed (Q2)

• reduced consumer surplus and choice

• regressive: indirect taxes take a larger proportion of income from low-income households than high-income households. If relatively price inelastic demand, consumer burden will be greater

What is the impact of indirect taxes on producers?

Impact of indirect taxes on producers=

• lower producer revenue and producer surplus

• burdened by the tax

• risk of shutting down or moving country

What is the impact of indirect taxes on workers?

Impact of indirect taxes on workers=

• potential job losses

• lower quantity produced means less demand for labour

What is the impact of indirect taxes on the government?

Impact of indirect taxes on the government=

• revenue generation: collects tax revenue P2bce

• market failure correction: decreases consumption/ production of demerit goods, improving societal welfare

• harm to consumers and producers

• regressivity- worsens income inequality

• black markets- can encourage illegal markets to avoid taxes

• deadweight loss- creates allocative inefficiency

What is the diagram for indirect taxes?

Diagram for indirect taxes=

• govt. revenue= P₂bce

• consumer burden (incidence)= portion of tax that is paid by consumers, reflected in the higher price, in the diagram= P₁P₂bd

• producer burden (incidence)= portion of taxthat is paid by producers; remaining part of govt. revenue after consumer burden, in the diagram= P₁dce

• producer revenue= decreases from P₁aQ₁O to ecQ₂O

• deadweight loss= loss of total surplus (consumer and producer surplus) due to tax→ allocative effiecieny, in the diagram= triangle abc

What is the incidence of tax if PED is perfectly elastic?

If the demand curve (PED) is perfectly elastic, the supplier will pay all the tax

What is the incidence of tax if PES is perfectly inelastic?

If the PES (supply curve) is perfectly inelastic, the supplier will pay all the tax

What is the incidence of tax if the PED is perfectly inelastic?

If the PED (demand curve) is perfectly inelastic, all the tax will be passed on to the consumer

What is the incidence of tax if the PES (supply curve) is perfectly elastic?

If the PES (supply curve) is perfectly elastic, all the tax will be passed onto the consumer

What happens if PED <1?

What happens if PED >1?

What is the diagram for subsidy?

What is a subsidy?

Subsidy= money grant to firms by government to reduce costs of production and encourage an increase in output

What are the core objectives of subsidies?

Core objectives of subsidies=

• solve market failures- encourage production and consumption of merit goods (e.g vaccinations, education)

• improve affordability- lower prices of necessities to help low- income households

What is the government cost, producer revenue, consumer savings and DWL in the subsidy diagram?

• government cost= are P2bcd

• consumer savings= P1P2ae

• DWL= abc

what is the impact of subsidies on consumers?

Impact of subsidies on consumers=

• lower prices

• higher consumer surplus

• better access to necessities

• future tax hikes

• cuts to other public services

• higher national debt

What is the impact of subsidies on producers?

Impact of subsidies on producers=

• massive revenue

• profit increases

• lower costs

HOWEVER, may become inefficient; “subsidy dependency”

What is the impact of subsidies on the government?

Impact of subsidies on the government=

• corrects market failure

• aids equality

HOWEVER, there’s an opportunity cost where money could have been spent elsewhere e.g NHS

What are the 3 reasons why consumers may not behave rationally?

3 reasons why consumers may not behave rationally=

• influences of other people

• influence of habitual behaviour

• consumer weakness at computation

Why is influences of other people a reason why consumers may not behave rationally?

Influences of other people a reason why consumers may not behave rationally= rationality assumes people act individually to maximise their own benefit but sometimes individuals are influenced by social norms. ‘herding behaviour’ when individual copies a large group

Why is influence of habitual behaviour a reason why consumers may not behave rationally?

Influence of habitual behaviour a reason why consumers may not behave rationally=

most people have habits that decrease the amount of time it takes to do something as consumers no longer consciously think about their actions, Habitual behaviour includes addictions that influence people’s decisions

Why is consumer weakness at computation a reason why consumers may not behave rationally?

Consumer weakness at computation a reason why consumers may not behave rationally=

many consumers aren’t willing and able to make comparisons between prices and so they will buy more expensive goods than needed e.g consumers but multipack goods assuming they’re cheaper. Also, consumers will make decisions without looking at the long-term effects e.g saving up for pensions