1.2.9 Indirect taxes and subsidies

What are indirect taxes?

Imposed by the government and they increase production costs for producers. Therefore, producers supply less. This increases market price and demand contracts

What are subsidies?

What are the two types of indirect taxes?

Ad valorem: taxes are percentages such as VAT which adds 20% of the unit price. Main indirect tax in the UK

  • Initial equilibrium is at P1Q1

  • The government places an ad valorem tax to raise government revenue

    • Supply shifts left due to the tax from S → S + tax

      • The two supply curves diverge as a percentage tax means more tax is paid at higher prices

  • The price the consumer pays has increased from P1before the tax, to P2 after the tax

  • The price the producer receives has decreased from P1before the tax to P3 after the tax

  • The government receives tax revenue = (P2-P3) x Q2

  • Producers and consumers each pay a share (incidence) of the tax

    • The consumer incidence (share) of the tax is equal to area A: (P2-P1) x Q2

    • The producer incidence (share) of the tax is equal to area B: (P1-P3) x Q2

  • New equilibrium is at P2Q2

    • Final price of goods/service is higher (P2) and QD is lower (Q2)

Specific taxes: A set tax per unit, such as 58p per litre fuel duty on unleaded petrol

  • Initial equilibrium is at P1Q1

  • Government places a specific tax on a demerit good and curve shifts left from S1-S2 by the amount of tax

  • Price the consumer pays has increased from P1( before the tax) to P2 after the tax

  • Price the producer receives has decreased from P1 (before the tax) to P3 (after the tax)

  • Gov receives tax revenue (P2-P3) x Q2

  • Producers and consumers each pay a share (incidence) of the tax

  • -Consumer incidence (share) of the tax is equal to area A: (P2-P1) x Q2

  • -The producer incidence of the tax is equal to area B: (P1-P3) x Q2

New equilibrium at P2Q2

  • Final price is higher and quantity demanded is lower (Q2)

Supply and demand analysis, elasticities and the impact of indirect taxes on consumers, producers and the gov

Supply and demand analysis, elasticities and the incidence of indirect taxes on consumers, producers and the gov

Supply and demand analysis, elasticities and the impact of subsidies on consumers, producers and the gov

Supply and demand analysis, elasticities and the incidence of subsidies on consumers, producers and the gov

The area that represents the producer subsidy and consumer subsidy