impact of indirect taxes and subsidies

What are direct taxes

A tax levied on the income, wealth or profits of the

person who pays it

E.g. income tax, corporation tax

What are indirect taxes

A tax levied on goods or services

E.g. Excise duties - specific tax

E.g. VAT - Ad valorem tax

What are specific taxes

A tax that is a fixed amount for each unit of a good

or service sold

◻ Main type we are concerned with are excise duties

What are ad valorem taxes

A tax whose amount is based on the value of the

transaction. Vat is currently 20%

Impact of indirect tax on consumers

Higher price - P1 to P2

◻ Lower quantity consumed - Q1 to Q2 (some

consumers ‘priced out’ of the good)

◻ Overall effect is to lower the consumer surplus in

the industry

◻ However:

Impact will depend on the PED

■ E.g. more inelastic products will see a larger change in price

and smaller change in quantity

■ The lower quantity consumed could be gooD for consumers if there is an information gap

Impact of indirect tax on producers

Raises the costs for producers (hence shift in

supply)

◻ Contraction of demand due to higher price - Q1 to

Q2

◻ Overall effect is to lower the producer surplus and

profit in the industry

Impact of indirect tax on governments

Creates revenue for the government

◻ Can also help to resolve market failure for

over-consumed goods

Impact of indirect tax on third parties

Negative externalities create an external cost and so

are over-consumed or over-produced

◻ Indirect taxes reduce quantity from Q1 to Q2 so help

to move output towards the socially optimal level

◻ Ideally the size of the tax should be equal to the

marginal external cost to achieve QSO

What is a subsidy

◻ A subsidy is a payment by the government to

suppliers that reduce their costs of production and

encourages them to increase output

Examples- solar panels, wind farms , education

Impact of subsidy on consumers

Lower price - P1 to P2

◻ Higher quantity consumed - Q1 to Q2 (some

consumers ‘priced in’ to the market)

◻ Overall effect is to increase the consumer surplus in

the industry

Impact of subsidy in producers

Lowers the costs for producers (hence shift in

supply)

◻ Extension of demand due to lower price - Q1 to Q2

◻ Overall effect is to increase the producer surplus

and profit in the industry

◻ However:

Impact will depend on the PED

■ E.g. more inelastic products - producer will gain less of the

subsidy → bigger drop in price and less increase in quantitY

Impact of subsidies on governments

Requires spending by the government - has to be

paid for through taxation, a budget deficit or

spending cuts elsewhere

◻ May not be best value for money - existing

consumers get the benefit as well as new

consumers

Impact of subsidies on third parties

Positive externalities create an external benefit and

so are under-consumed

◻ Indirect taxes increase quantity from Q1 to Q2 so

help to move output towards the socially optimal

level

◻ Ideally the size of the subsidy should be equal to

the marginal external benefit to achieve QSO