Taxation and Subsidies

Question 1

Pigouvian Tax

Answer 1

A Pigouvian tax is a tax placed on any good which creates negative externality. The aim of a Pigouvian tax is to make the price of the good equal to the social marginal cost and create a more socially efficient allocation of resources.

Question 2

Indirect Tax

Answer 2

When a tax is imposed, supply-side conditions for firms producing these goods will become less favourable. By having their profits cut, producers will be discouraged from producing or supplying the item, causing a decrease in supply at all possible prices.

Question 3

Indirect Tax

Answer 3

The decrease in supply following the introduction of an excise tax means that supply shifts left by an amount equal to the level of tax per unit. This leads to an increase in price, and now buyers have to pay the higher, less attractive equilibrium price, causing demand to contract. However, following the tax, suppliers of this socially undesirable good will receive a much lower, less profitable price equal, cutting the quantity they produce. The difference between the buyer’s and seller’s prices represent the sale tax per unit sold.

Both buyers and sellers of this item each share part of the tax burden. This policy changes behaviour and discourages both production and consumption of the item, repelling resources from this socially undesirable area.

REFER TO DIAGRAMS IN LESSON 8

Question 4

Pigouvian Subsidy

Answer 4

A Pigouvian subsidy works on the same basis - if a good has positive externalities, then it will be under-consumed in a free market. The government can give a subsidy equal to the marginal external benefit of the good.

Question 5

Subsidies

Answer 5

A government cash subsidy could also be used to encourage consumers of a product to change behaviour that currently cause negative externalities. For instance, paying cash incentives to households installing solar panels or rainwater tanks could help reduce negative externalities. Additionally, in cases where the existence of positive externalities leads to the underproduction of merit services that are deemed socially beneficial such as education and health, a case exists for the government to make more of these services available by paying a subsidy to private producers.

Question 6

Subsidies

Answer 6

With a subsidy, the supply of the service at any given price would increase and thus shift the line outwards from S1 to S2. Additionally, the equilibrium price will fall. Resultantly, the new price paid by buyers will fall (making this socially desirable outcome more desirable item cheaper and thus more attractive to consume), while the new higher price P3 is received by sellers, would make this socially desirable outcome more profitable to produce. The price difference represents the value of the government cash subsidy per unit of output produced. Notice too, that the quantity of this socially desirable outcome has grown, indicating that more resources than previously are allocated to this desirable area, reducing market failure.