Indirect taxes and subsidies 1

1. Indirect taxes Taxes levied on spending to buy g/s. They are indirect because they involve payment of some of the tax by the consumer, they are paid to the government authorities by firms, indirectly. Recall: When tax is imposed on a g/s, supply curve will shift to the left by the amount of tax, and firm is less willing to produce output 2. Examples of indirect taxes Excise taxes (taxes on specific g/s, like cigarettes) General sales tax Value added tax (VAT)

2. 2 types of indirect taxes Specific tax: Fixed amount of tax that is imposed upon a product - Shift of supply curve is parallel, because tax is an absolute amount for each unit of output sold, and thus, is same for all prices

Ad valorem tax (percentage tax) : Fixed percentage of the price of the g/s - New supply curve is steeper than original supply curve, as absolute amount of tax increases as price increases

2 Indirect taxes and subsidies

3. Incidence of indirect taxes Tax incidence refers to the burden of a tax, or those who are the ultimate payers of tax. The distribution of tax burden (who has a larger or smaller burden) depends on the price Elasticities of demand and supply. 3. Imposition of indirect tax (general) (for specific tax) a. What will happen to consumer and produce ?

Producer revenue graph graph 1. The original price is Pe and original quantity is Qe.

Tax burden

Indirect taxes and subsidies 3

2. Specific tax is XY per unit imposed 3. Supply curve shifts vertically from S1 to S1 + tax 4. Producer raise price to P2, so pass on all the cost of tax to consumers 5. However, at the new price, there is an excess supply, and so price has to fall until 6. New equilibrium is reached at P1 and Q1 7. Consumer: Price of the product for consumer rises from Pe to P1, which is their share of the tax and is half of the whole tax XY 8. Producer: Receive C per unit, after paying XY to the government Contribute to rest of the tax, PeC per unit Revenue FALLS from 0PeCWQe to 0CYQ1.

b. What will happen to government, size of market and employment?

1. Government receive tax revenue equal to CP1XY 2. Market falls in size from producing Qe units to producing Q1 units. 3. Implications: level of employment in the market, and firms might

4 Indirect taxes and subsidies

employ less people.

4. Incidence of indirect taxes and elasticity - Share of tax burden for consumer and producer, government, size of market, employment will vary with elasticity of demand and supply When government imposes a specific tax on a product: a. Incidence of tax when demand is elastic and PES is inelastic

1. The original price is Pe and original quantity is Qe. 2. Specific tax is XY per unit imposed 3. Supply curve shifts vertically from S1 to S1 + tax 4. Producer raise price to P2, so pass on all the cost of tax to consumers 5. However, at the new price, there is an excess supply, and so price has to fall until 6. New equilibrium is reached at P1 and Q1 BUT producer cannot pass on a lot of burden of tax, because demand is elastic and too many consumers will stop buying product. Producers will bear burden themselves. 7. Consumer: Price of the product for consumer rises a little from Pe to P1. 8. Producer: Receive C per unit, after paying XY to the government Contribute the marjority of the tax, PeC per unit

Indirect taxes and subsidies 5

Income FALLS by large amount from 0PeCWQe to 0CYQ1.

9. 1. Government receive HIGH tax revenue equal to CP1XY 10. Market falls in size from producing Qe units to producing Q1 units. 11. Implications: level of employment in the market, and firms might employ less people. Therefore, Burden of indirect tax heavier on producer because of elasticity. b. Incidence of tax when demand is inelastic and PES is elastic

1. The original price is Pe and original quantity is Qe. 2. Specific tax is XY per unit imposed 3. Supply curve shifts vertically from S1 to S1 + tax 4. Producer raise price to P2, so pass on all the cost of tax to consumers 5. However, at the new price, there is an excess supply, and so price has to fall until 6. New equilibrium is reached at P1 and Q1 SO, producer can pass on a lot of burden of tax, because demand is inelastic and few consumers will stop buying product. Consumers will bear most of the burden.

6 Indirect taxes and subsidies

7. Consumer: Price of the product for consumer rises a lot from Pe to P1, and contribute the majority of the tax, P1Pe per unit. 8. Producer: Receive C per unit, after paying XY to the government Income FALLS by a small amount from 0PeCWQe to 0CYQ1.

9. 1. Government receive HIGH tax revenue equal to CP1XY 10. Market falls in size from producing Qe units to producing Q1 units. 11. Implications: level of employment in the market, and firms might employ less people. Therefore, Burden of indirect tax heavier on consumer because of elasticity.

SUMMARY: PED = PES for a product Burden of tax shared between consumer and producer of the product Burden of tax is more for producer than consumer Burden of tax is more for consumer than producer

PED > PES PED < PES

To note: Therefore, government like to indirectly tax products that have inelastic demand like alcohol and cigarettes. 5. Subsidies A subsidy is an amount of money paid by the government to a firm per unit output.

6. Incidence of subsidies (general) a. What will happen to consumer and produce ?

Indirect taxes and subsidies 7

Producer revenue graph expenditure graph 1. The original price is Pe and original quantity is Qe. 2. Subsidy XY per unit imposed

Consumer

3. Supply curve shifts vertically downwards from S1 to S1 + subsidy 4. Producer lower price to P2, 5. Increase output until 6. New equilibrium is reached at P1 and Q1 7. Consumer: Price of the product to consumer falls from Pe to P1 (not by the whole amount of subsidy (they pay 0P1ZQ) Save expenditure of P1PeXY Purchase more units QeQ1, as price is lower, spending QeYZQ1 Total consumer expenditure may increase or fall, depending on relative savings and extra expenditure

8. Producer: Income for producer rises from original amount 0PeXQe to 0DWQ1

8 Indirect taxes and subsidies

b. What will happen to government, size of market and employment?

1. Cost of government subsidy equal to P1DWZ 2. Oppurnity cost of subsidy: government take away from money from other areas of expenditure (e.g. building infrastructure, or it raise taxes) 6. Incidence of subsidies and Elasticities When government gives subsidy a. Incidence of when demand is PES is inelastic subsidy elastic and

Indirect taxes and subsidies 9

1. The original price is Pe and original quantity is Qe. 2. Subsidy is YW per unit imposed 3. Supply curve shifts vertically downwards from S1 to S1 + tax 4. Producer lower price to P2 5. Increase output until 6. New equilibrium is reached at P1 and Q1 7. Price to consumers fall from Pe to P1, a SMALL part of the subsidy If whole subsidy is passed on 7. Consumer: Pay 0P1WQ1 Consumption increased Do no benefit from a great price fall, but will consume a lot more

8. Producer: Income will rise from original 0PeXQe to 0DYQ1 P1DYW is paid to the producers by government as subsidy Revenue increased

b. Incidence of subsidy when demand is inelastic and PES is elastic

10 Indirect taxes and subsidies

1. The original price is Pe and original quantity is Qe. 2. Subsidy is YW per unit imposed 3. Supply curve shifts vertically downwards from S1 to S1 + tax 4. Producer lower price to P2 5. Increase output until 6. New equilibrium is reached at P1 and Q1 7. Price to consumers fall from Pe to P1, a BIG part of the subsidy If whole subsidy is passed on 7. Consumer: Pay 0P1WQ1 Consumption increased Do no benefit from a great price fall, but will consume a lot more

8. Producer: Income will rise from original 0PeXQe to 0DYQ1 P1DYW is paid to the producers by government as subsidy Revenue increased

SUMMARY: PED = PES for a product PED > PES PED < PES Price of product fall by half of the subsidy Price will fall by less than half of the subsidy Price will fall by more than half of the subsidy Consumption rise, income of producer increase

Indirect taxes and subsidies 11

9. Factors to take into account for when granting subsidies (Brief) No. 1 2 3 Factor Opportunity cost of government spending on subsidy in terms of other alternative government spending projects Whether subsidy will cause firms to be inefficient If they do not have to compete with foreign producers Although subsidy allows consumers to buy products at lower cost, there may be taxpayers who are funding the subsidies. Who is paying the tax? 4 Damge to sales of foreign producers who are not receiving subsidies from their governments.