1.2.9 - Indirect taxes and subsides Flashcards
Indirect taxes
Taxes paid on the consumption of goods/services.
e.g
- Ad valorem tax : A tax that is a percentage of the purchase price e.g VAT.
- Specific tax : A fixed tax per unit of output (specific amount). e.g excise duties.
What is Producer burden
The amount by which the imposition of an indirect tax will reduce producer surplus.
The producer burden is the decline in revenue firms face after paying the tax.
What is Consumer burden
The amount by which consumer surplus is reduced by the imposition of an indirect tax.
The consumer burden is the extra amount the consumers pay.
Draw a Ad valorem tax diagram.
For example VAT in the UK is 20% which is then added onto the original price. Ad valorem taxes are shown by two supply lines that get further and further away from each other. This is due to the fact that as the price of the good/service increases, the more the Ad valorem tax increases. This can be seen on the diagram below
Draw a Specific Tax diagram.
This is in contrast to a specific tax where the amount of tax paid is the same regardless of the price of the good/service. As a result of this, a specific tax is shown by two parallel supply lines where supply decreases, as shown in the diagram below.
Remember that the burdens are
1. Consumer burden
2. Producer buren
The specific tax increases production costs for the firm and therefore supply decreases from S1 to S1+tax. This causes price to increase from P1 to P1. As a result, quantity decreases from Q1 to Q2 thus helping to reduce consumption as well as production of the good/service. This is the reason why taxes are usually placed on de-merit goods such as cigarettes which harm society.
- Tax per unit = The vertical difference between S1 and S1+tax.
- Government rev = Tax per unit x Quantity of goods sold. P2-d-c-b
- Consumer burden = P2 - d - e - P1.
- ** Producer burden** = P1-e-c-b
- Producer revenue = Due to the tax that has been placed on the good, producer revenue has fallen from P1-a-Q1-0 to b-c-Q2-0.
Welfare loss to society for tax diagram.
- The government revenue in the FM is 0 as the tax hasn’t been implemented yet.
- After the tax has been applied, consumer surplus falls from A+B+E to just A. This is due to the rise in the market price caused by the tax from P1 to P2.
- Producer surplus falls from C+D+F to just D. This is due to the tax B+C meaning the producer no longer gains the profit of C+F
- The government revenue after the tax is equal to B+C (the difference between P2 and PT multiplied by quantity Q2).
- . This means that the total surplus after the tax has been implemented is A+B+C+D.
- As you may have noticed this means that area E+F is no longer accounted for. As a result of this, there has been a deadweight welfare loss of area E+B. This means that overall; society is worse off as a result of the implementation of the indirect tax.
Draw and explain an indirect tax diagram with an Inelastic demand curve.
If a tax is implemented on a good/service that is relatively price inelastic it will result in a large increase in price (P1 to P2), but only a small decrease in quantity (Q1 to Q2). Therefore the effect of a tax used on a price inelastic good/service is relatively ineffective when trying to decrease the consumption/production of that product. Furthermore, the consumer takes the majority of the burden.
producers know that the good/service they sell is price inelastic and therefore they know that they are able to increase their prices without suffering from a large decrease in quantity e.g cigarettes that are addictive have a low price elasticity of demand. This means that despite a large increase in price (P1 to P2) consumers are unwilling to reduce the quantity of cigarettes that they consume by a significant amount as they’re addictive.
However, the benefit to the government of implementing an indirect tax on price inelastic goods/service is that they produce a much larger amount of government revenue (P2-d-c-b) than indirect taxes placed on price elastic goods.
- Consumer burden = P2-d-e-P1
- Producer burden = P1-e-c-b
-
Producer revenue =
P1-a-Q1-0 to b-c-Q2-0. - Government rev = P2-d-c-b
Draw and explain an indirect tax diagram with an Elastic demand curve.
When taxing goods/services that are price elastic, the reduction in supply caused by the tax (S1 to S1+Tax) has little impact on price (P1 to P2), but a big impact on the quantity consumed and supplied (Q1 to Q2).
This allows only a small tax to be implemented in order to cause a large reduction in the consumption or production of a good/service. Therefore taxation is usually a good policy to implement if demand is elastic when trying to reduce negative externalities.
- Consumer burden = P2-d-e-P1
-
Producer revenue =
P1-a-Q1-0 to b-c-Q2-0. -
Producer revenue =
P1-a-Q1-0 to - Gov Rev = The large fall in quantity (Q1 to Q2) means that the total government revenue from the indirect tax (P2-d-c-b) is much less than if the good/service was price inelastic. This is because far less people are now buying the good/service and therefore far less people are paying the indirect tax. Furthermore, the quantity of good/service being produced has also decreased from Q1 to Q2 meaning there are less goods/service to place the indirect tax onto.
Draw and explain an
subsidy diagram.
- the introduction of a subsidy means that firms are more incentivised to produce more of the good/service and those firms that weren’t currently in the market are more incentivised to join the market.
- As a result of this, price decreases from P1 to P2 and quantity increases from Q1 to Q2.
- Total cost of subsidy to the gov = multiplying the subsidy cost per unit by the quantity Q2. a-b-c-P2
- Producer saving = Before the subsidy, producers were getting P1-d-Q1-0. After the subsidy Producers are getting 0-a-b-Q2 and therefore gaining the extra revenue of a-b-c-P2.
- Consumer savings = before the subsidy were paying price P1 at a quantity of Q1. They’re now paying price P2 at a quantity of Q2. This means the overall consumer saving from the subsidy is P1-d-e-P2.
Welfare loss for a subsidy diagram.
- In the free market consumer surplus is A+B, which is the area above the market price (P1).
- After the subsidy market price decreases to P2 causing consumer surplus to increase to A+B+C+F+G(the area above P2 within the demand curve).
- Producer surplus increases from C+D to B+C+D+E (the area below PS and above S1). This is due to the fact that the producer keeps some of the subsidy giving them a producer surplus up to price PS rather than P2.
fully annotated s&d
Subsidy
A grant from the government to a firm, meant to encourage production and consumption of a good or service
