Indirect Taxes and Subsidies

Government Intervention

What is an indirect tax?

A tax paid on the consumption of goods/services, which the tax burden is passed from producers to consumers

Why may the government impose a indirect tax?

• Discourage consumption of demerit goods

• Raise government revenue

How is the indirect taxes transferred?

1. Governments put the tax on producers → why the supply curve shifts

2. Producers put it on their products which then is paid by the consumers

What are the two types of indirect taxes?

1. Ad valorem

2. Specific

What is a specific tax?

A fixed tax per unit of output (specific amount)

What is tax incidence?

The share/burden of the total tax to be paid

In this diagram, what is the consumer incidence (share) and producer incidence (share) of the tax?

• Consumer incidence: AREA A = P2-P2 x Q2

• Producer incidence: AREA B = P1-P3 x Q2

What is a ad valorem tax?

A tax that is a percentage of the purchase price

• The more goods/services consumed, the larger the tax bill

• Causes supply curve to diverge from original supply curve

• Raises significant government revenue

In this diagram, what is consumer and producer incidence?

• Consumer incidence: Area A = P2-P1 x Q2

• Producer incidence = Area B = P1-P3 x Q2

What are the advantages of indirect taxes?

• Raise the price and reduces the QD 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 foods depends on the PED

  • Many consumers who purchase products that are price inelastic will continue to do so

• It may help create illegal markets as consumers seek to avoid paying the taxes

• Producers may be forced to lay off some workers as output falls due to the higher prices

How does PED influence the effectiveness of indirect taxes?

Inelastic goods:

• Curve is steep

• Producers pass on much higher proportion of the tax to consumers and pay the rest themselves

• QD decreases but in a much smaller proportion compared to the increase in price

Elastic goods:

• Curve is flatter

• Producers pass on a much smaller proportion of the tax to consumers and pay the rest themselves

• QD decreases but by a much larger proportion in comparison to the increase in price

Both goods:

• Increase in price and decrease in QD

• Tax revenue is collected

What are subsidies?

The per unit amount of money given to a firm by the government to increase production or increase the provision of a merit good

How is a subsidy shared between producers and consumers?

• Producers keep some of the subsidy

• Pass the rest to consumers in the form of lower prices

• Determined by the PED of the product

What are the advantages of producer subsidies?

• Can be targeted to helping specific domestic industries

• Lower prices and increases demand for merit goods

• Helps to change destructive consumer behaviour over a longer period of time

• Can be used to help domestic firms compete internationally

What are the disadvantages of producer subsidies?

• Distorts the allocation of resources in markets

• There is an opportunity cost associated with the government expenditure

• Subsidies are prone to political pressure and lobbying by powerful business interests

• Subsidies can disincentives firms from becoming more efficient or competitive as they provide extra funds which reduce the need to be more competitive