Indirect Taxation & Subsidies

What is an indirect tax?

A tax added to goods/services when they are bought

Who is the tax placed on?

Producers, but they often pass it onto consumers via higher prices.

Why do governments use indirect taxes?

To:

• Reduce consumption of harmful goods

• Raise government revenue

How does an indirect tax reduce consumption?

• Raises price

• Reduces quantity demanded
  → discourages demerit goods

What happens to supply when a tax is added?

Supply shifts left/upwards (costs increase).

What is tax incidence?

How the tax burden is split between consumers and producers.

Give advantages of indirect taxes.

• Reduce consumption of harmful goods

• Lower negative externalities

• Raise government revenue

Why might taxes not reduce demand much?

If demand is price inelastic (e.g. cigarettes).

Other disadvantages?

• Black markets may form

• Job losses if demand falls

• Can be regressive (affects poor more)

Who pays more tax if demand is inelastic?

Consumers.

Who pays more tax if demand is elastic?

Producers.

What is a subsidy?

Money given by the government to firms per unit produced.

Why do governments use subsidies?

To increase consumption of merit goods.

What do subsidies do to costs?

Reduce production costs.

How is the subsidy shared?

• Consumers get lower prices

• Producers get higher revenue

Benefits of subsidies?

• Increase consumption of merit goods

• Make goods more affordable

• Help reduce poverty

• Support industries

Why can subsidies be inefficient?

They distort the market → wrong allocation of resources.

What is the opportunity cost?

Money could be spent elsewhere (e.g. healthcare, education).

Other disadvantages?

• Can cause overproduction

• Reduce incentives for firms to be efficient

• Influenced by lobbying

What determines effectiveness of taxes/subsidies?

PED & PES

Key evaluation point?

Always mention elasticity when analysing impact.