Indirect Taxes And Subsidies

Question 1

What is indirect tax?

Answer 1

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

Question 2

What are the two types of indirect tax

Answer 2

Specific or ad valorem, which are levied by the government and producers, which is why the supply curve shifts

Question 3

Describe a diagram that demonstrates the incidence of a specific tax

Answer 3

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
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
The QD in this market has decreased from Q1→Q2
If the decrease in QD is significant enough, it may force producers to lay off some workers

Question 4

How does price elasticity of demand of the product impact tax indicence?

Answer 4

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
For an inelastic product (e.g., cigarettes), 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)
For an elastic product (e.g., pizza), 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)

Question 5

What is a subsidy?

Answer 5

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

Question 6

What determines the incidence of the subsidy?

Answer 6

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

Question 7

Describe a diagram, which would demonstrate the cost of a subsidy to the government and the incident received by the consumer and producer

Answer 7

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