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?

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

What are the two types of indirect taxes? Ad valorem and specific taxes

Ad valorem: A tax that is a percentage of the purchase price: 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)

Subsidies

  • A producer subsidy is a per unit amount of money given to a firm by the government

    • To increase production

    • To increase provision of a merit good

  • The incidence (share) of the subsidy is determined by the PED of the product

    • If governments subsidise goods/services with high PED, the increase in QD will be more than proportional to the decrease in price 

    • Producers keep some of the subsidy and pass the rest on to the consumers

  • The original equilibrium is at P1Q1

  • The subsidy shifts the supply curve from S → S + subsidy:

    • This increases the QD in the market from Q1→Q2

    • The new market equilibrium is P2Q2

    • This is a lower price and higher QD in the market

  • Producers receive P2 from the consumer PLUS the subsidy per unit from the government 

    • Producer revenue is therefore P3 x Q2

    • Producer incidence of the subsidy is marked B in the diagram

  • The subsidy decreases the price that consumers pay from P1 → P2

    • Consumer incidence of the subsidy is marked A in the diagram

  • The total cost to the government of the subsidy is (P3 - P2) x Q2 represented by area A+B