INDIRECT TAXES AND SUBSIDIES
How might government policies
change the cost of products and
services?
Learning objectives
By the end of this lesson, you should be able to:
1. Distinguish between indirect taxes and subsidies
2. Explain why government impose indirect taxes or
grant subsidies to producers
3. Apply demand and supply diagrams to examine
the impact of indirect taxes and subsidies on
consumers, producers and government
Government intervention to correct
market failure
• The change in price of a good or service might be the result of
government intervention
• This includes:
– Indirect taxes
• Taxation is the medium through which governments finance their
spending and control the economy
• It is a charge imposed on products, individuals and businesses
– An indirect tax is a tax on a good or a service
– A direct tax is a tax on an individual or an organisation.
– The incidence (or burden) of tax is the amount that the consumer
(or producer) will pay for the tax
– Subsidies
• A subsidy is a financial incentive to produce or consume a given product
Indirect taxes
S with tax
The imposition of an indirect tax will lead to an
increase in the cost of supply for a firm. This will
S
Price lead to a shift in the supply curve up and to the left.
Tax Quantity supplied will decrease by Q-Q1. P will
P1
increase from P to P1.
P
The increase in tax has caused the price to rise by
P0
the vertical distance between the supply curves.
The incidence (amount) of the tax paid for by the
producer is shown by the blue line (equivalent to P-
D
P0). The incidence of the tax paid for by the
consumer is shown by the green line (P1-P).
Q1 Q
Quantity
The incidence / burden of indirect taxes
S with tax
S
Price
Tax
F
E
J G
I
H
Q1 Q
Quantity
1. Incidence of tax on consumers = FG
2. Incidence of tax on producers = GH
3. Tax paid by consumers = EFGJ
4. Tax paid by producers = GHIJ
5. Government revenue from tax = EFHI
Effect of PED on the impact and
incidence of indirect taxes
S with tax
S
Price
If demand is price inelastic the
incidence of the tax will be greater for
the consumer.
Quantity
S with tax
Price
S If demand is price elastic the incidence
of the tax will be greater for the
producer.
Quantity
Effect of PES on the impact and incidence
of indirect taxes
S with tax S
Price If supply is price inelastic the
incidence of the tax will be greater for
the producer.
Quantity
Price S with tax
If supply is price elastic the
S incidence of the tax will be greater
for the consumer.
Quantity
OVERALL CONCLUSION: Indirect taxes and elasticity
When value of PED = value of PES BURDEN OF TAX SHARED EQUALLY
BETWEEN THE CONSUMERS AND
PRODUCERS OF THE PRODUCT
When value of PED > value of PES BURDEN OF TAX IMPOSED WILL BE
(demand is relatively elastic) GREATER ON THE PRODUCERS OF THE
PRODUCT THAN ON THE CONSUMERS
When value of PED < value of PES BURDEN OF TAX IMPOSED WILL BE
(demand is relatively inelastic) GREATER ON THE CONSUMERS OF THE
PRODUCT THAN ON THE PRODUCERS
There are three main reasons why governments place indirect taxes on products
that have relatively INELASTIC DEMAND e.g. alcohol, cigarettes:
Demand falls by a proportionally smaller amount than the change in price, so
1. High tax revenue is gained
2. There is a reduction in quantity demanded and supplied by the market (some
effect on consumer behaviour). This may be perceived as beneficial, as these
products may be considered as ‘undesirable’ by society as a whole (DEMERIT
GOODS AND SERVICES).
Different types indirect tax
SPECIFIC INDIRECT TAX
• Definition: fixed amount of tax PER UNIT imposed upon a product
– e.g. £1 specific indirect tax per bottle of beer
• Effect on supply curve: PARALLEL SHIFT in the supply curve vertically upwards BY
THE AMOUNT of the tax
AD VALOREM INDIRECT TAX
• Definition: tax is a PERCENTAGE of the selling price e.g. 20% ad valorem tax added
to selling price of a pair of shoes
• Effect on supply curve: NOT A PARALLEL SHIFT – curve shifts vertically upwards by
the amount of the tax, but the GAP BETWEEN THE TWO CURVES GETS BIGGER as
the price of the product rises – the gap between the two supply curve widens
Specific indirect tax Ad valorem indirect tax
Price per unit
Price per unit
£4
£1
£1
£1
Quantity Quantity
Subsidies
A subsidy is a financial incentive to produce or consume a given product
.
The granting of a subsidy will lead
to a decrease in the cost of supply
S
for a firm. This will lead to a shift
S with subsidy in the supply curve down and to
Price
P0
Subsidy the right. Quantity supplied will
P
increase by Q-Q1. P will decrease
P1 from P to P1.
The subsidy has caused supply to
D
rise by the vertical distance (P1-P0)
between the supply curves. The
subsidy will be shared between the
Q Q1
Quantity
consumer and the producer.
Consumer and producer benefit of
subsidy
.
.
OVERALL CONCLUSION: Subsidies and elasticity
When value of PED = value of PES SUBSIDY SHARED EQUALLY BETWEEN
THE CONSUMERS AND PRODUCERS OF
THE PRODUCT
When value of PED > value of PES BENEFIT OF THE SUBSIDY WILL BE
(demand is relatively elastic) GREATER FOR PRODUCERS THAN
CONSUMERS
When value of PED < value of PES BENEFIT OF THE SUBSIDY WILL BE
(demand is relatively inelastic) GREATER FOR CONSUMERS THAN
PRODUCERS
There are three main reasons why governments grant subsidies on products that
have relatively ELASTIC DEMAND e.g. fruit, vegetables:
Demand increases by a proportionally larger amount than the change in price, so
1. Less government expenditure is required
2. There is a relatively larger increase in quantity demanded and supplied by the
market (some effect on consumer behaviour). This is perceived as beneficial, as
these products may be considered as ‘desirable’ by society as a whole (MERIT
GOODS AND SERVICES).
Learning objectives check
Now you should be able to:
1. Distinguish between indirect taxes and subsidies
2. Explain why government impose indirect taxes or
grant subsidies to producers
3. Apply demand and supply diagrams to examine
the impact of indirect taxes and subsidies on
consumers, producers and government
