2.7.2 Government Intervention: Indirect Taxes & Subsidies

• An indirect tax is paid on the consumption of goods/services
  • It is only paid if consumers make a purchase
  • It is usually levied by the government on demerit goods to reduce the quantity demanded (QD) and/or to raise government revenue
  • Government revenue is used to fund government provision of goods/services e.g education
    
    
• Indirect taxes are levied by the government on producers. This is why the supply curve shifts 
   
• An indirect tax can be either ad valorem or specific
   

1. A Specific Tax

• A specific tax is a fixed tax per unit of output (specific amount) e.g. $3.25/packet of cigarettes

The impact of an indirect tax is split between the consumer (A) and the producer (B)
 

 Diagram Analysis

• Initial equilibrium is at P₁Q₁
• The government places a specific tax on a demerit good
  • The supply curve shifts left from S₁→S₂ by the amount of the tax
• The price the consumer pays has increased from P₁ before the tax, to P₂ after the tax
• The price the producer receives has decreased from P₁ before 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 is higher (P₂) and QD is lower (Q₂)
  • If the decrease in QD is significant enough, it may force producers to lay off some workers

  

2. Ad Valorem Tax

• A tax that is a percentage of the purchase price e.g. Value added tax (VAT) in Columbia in 2022 was 19%
  • The more goods/services consumed, the larger the tax bill
  • This causes the second supply curve to diverge from the original supply curve
  • VAT raises significant government revenue

A diagram showing an ad valorem tax (VAT) and the tax incidence for producers and consumers
  

Diagram Analysis

• 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 P₁ before the tax, to P₂ after the tax
• The price the producer receives has decreased from P₁ before 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)
  • If the decrease in QD is significant enough, it may force producers to lay off some workers

Exam Tip

The Advantages and Disadvantages of Indirect Taxes

Advantages	Disadvantages
Raises the price and reduces the quantity demanded of demerit goods Reduces external costs of consumption and production Raises revenue for government programs	The effectiveness of the tax in reducing the use of demerit goods depends on the price elasticity of demand (PED) Many consumers who purchase products that are price inelastic in demand will continue to do so It may help create illegal markets as consumers seek to avoid paying the taxes Producers may be forced to lay off some workers as output falls due to the higher prices

  

A side by side Comparison of the Impact of PED on Tax Incidence

• Aiming to maximise their profits, producers pass on as much of the indirect tax as they can to consumers and pay the balance themselves
• The amount passed on to consumers depends on the price elasticity of demand (PED) of the product

A diagram that demonstrates the tax incidence for a product whose PED is inelastic (left) and elastic (right). A is the consumer incidence and B is the producer incidence
  

Diagram Analysis

1. In both diagrams
   
   • The specific tax shifts the supply curve from S₁→S₂
   • There is a higher market price at P₂ and lower QD at Q₂
   • Tax revenue for the government is the sum of A+B
   • Consumer incidence is represented by A and producer incidence by B
   • Total revenue for the seller is calculated using P₃ X Q₂
   • The difference in PED results in a different steepness to the demand curve
      
2. For an inelastic product (e.g. cigarettes)
   
   • The curve is steep
   • Producers pass on a much higher proportion of the tax to consumers (A) and pay the rest themselves (B)
   • The QD decreases (Q₁→Q₂) but by a much smaller proportion than the increase in price (P₁→P₂)
      
3. For an elastic product (e.g. pizza)
   
   • The curve is much flatter
   • Producers pass on a much smaller proportion of the tax to consumers (A) and pay the rest themselves (B)
   • The QD decreases (Q₁→Q₂) but by a much larger proportion than the increase in price (P₁→P₂)

Exam Tip

• A producer subsidy is a per unit amount of money given to a firm by the government
  • To increase production
  • To increase the provision of a merit good
    
    
• The way a subsidy is shared between producers and consumers is determined by the price elasticity of demand (PED) of the product
  
  • Producers keep some of the subsidy and pass the rest on to the consumers in the form of lower prices

A diagram which demonstrates the cost of a subsidy to the government (A+B) and the share received by the consumer (A) and producer (B)

Diagram Analysis

• 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 share of the subsidy is marked B in the diagram
• The subsidy decreases the price that consumers pay from P₁ → P₂
  • Consumer share 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  

Exam Tip

The Advantages and Disadvantages of Producer Subsidies

Advantages

Disadvantages

Can be targeted to helping specific domestic industries Lowers prices and increases demand for merit goods Helps to change destructive consumer behaviour over a longer period of time e.g. subsidising electric cars makes them affordable and helps motorists to see them as an option for the masses, not just the wealthy Can be used to help domestic firms compete internationally

Distorts the allocation of resources in markets e.g. it often results in excess supply when used in agricultural markets There is an opportunity cost associated with the government expenditure - could the money have been better used elsewhere? Subsidies are prone to political pressure and lobbying by powerful business interests e.g. most oil companies receive subsidies from their respective governments (despite making $billions in profits each year) Subsidies can disincetivise firms from becoming more efficient or competitive. They provide extra funds which reduce the need to be more competitive