1.2.9: Indirect taxes and subsidies

Indirect taxes

• Taxes imposed by the government which increase production costs for producers

• As a result, they supply less and increase the market price

• As a result, demand contracts

What are Ad valorem taxes?

• Taxes that are a percentage of a good/service

• E.g: VAT which adds 20% of the unit pice

• This is the main indirect tax in the UK

• Since the tax is a percentage of the cost of the good the absolute value of the tax increases as the price of the good increases

• If demand is inelastic, government revenue from the tax is higher than if elastic

• If the tax is implemented with the intention of internalising the externality, it is hard to put a monetary value on the externality e.g. pollution

• Internalising the externality means the individual or firm which causes the negative externality pays for the damage

• Some taxes could be expensive for the government to collect

• Some taxes could be regressive

• Taxes could be inflationary

What are specific taxes

• Another type of indirect tax

• Taxes that are set tax per unit

• E.g: the £5 tax on each pack of cigarettes or £10 tax per bottle of alcohol

The burden of tax with different PEDs

• If demand is more elastic, the incidence on tax will fall mainly on the supplier

• If demand is more inelastic, the incidence of the tax will be placed mainly on the consumer

Subsidies

• A payment from the government to the producer to lower their costs of production and encourage them to produce more

• E.g: apprenticeship schemes

• They shift the supply curve right which lowers market price

Effects of subsidies

• Increased output and lower costs for consumers which could help those low and fixed incmes

• Increases the employment rate, by making workers more skilled through apprenticeship schemes and lowering the costs of employing workers

• Reduces inequality in society if the subsidy is progressive

• Could help control inflation by keeping production costs low

• Could help produce demand during periods of economic decline

• Subsidies could encourage the consumption of merit goods, which creates positive externalities

• LRAS could increase if the subsidy is aimed towards a capital

• Could be government failure if the government provides an inefficient subsidy or if it distorts the market price

• Government revenue could be spent better elsewhere- opportunity costs of the subsidy should be considered

• Tax payers usually pay for the subsidy, and may receive no direct benefit from it

• If demand is price inelastic, the subsidy will have a large effect on equilibrium price which gives a greater consumer gain than when demand is elastic

Producer and consumer subsidies

• A consumer subsidy encourages consumers to purchase more of a particular good or service

• It could be a direct grant or a loan without interest

• E.g: Consumer subsidies affect demand and do not shift the supply curve

• Producer subsidies lower the cost of production and shift the supply curve