Taxation & Subsidies Flashcards
How can the government use indirect taxation to rectify market failure?
Governments intervene in markets to rectify market failure.
Cases where a product is over provided by a market. Indirect taxation increases the price, reducing demand and market output.
How does indirect taxation effect the supply curve?
Indirect taxation increases the cost of production and increases the cost to the consumers, so shifts the supply curve inwards.
How do subsidies effect the supply curve?
Subsidies decrease the cost to the consumer so shifts the supply curve outwards.
What are 2 ways the government can intervene to shift supply curves?
• Indirect taxation
• Subsidies
What is Indirect Taxation?
Tax which is not directly paid to the government by an individual.
What is Unit Tax and what shift does it cause?
The same amount of tax is paid for each unit produced. E.g. Alcohol Duty.
Parallel Shift.
What is Ad valorem Tax and what shift does it cause?
Tax is paid as a percentage of the price of the product. E.g. VAT at 20%.
Causes a rotational shift.
What is the process of indirect taxation?
• Indirect taxation increases the cost of production
• Shifts supply curve inwards
• Vertical distance between the supply curves is the value of tax
• Producers want to pass on all of the tax
• Price rises to P1
• Market equilibrium quantity falls to Q1
• Price rise represents tax passed onto consumers
How is indirect tax paid?
• Passed onto consumers by producers by rising prices
• Remainder of tax is absorbed by producers
• How much paid by each group dependent on PED
• PED also impacts the effectiveness of tax
Tax Revenue Formula
Tax Revenue =
Tax Value x New Quantity
How can indirect tax effect negative externalities of production?
• Indirect taxation can eliminate the deadweight loss
• Increases the cost of the product so shifts the MPC curve inwards
• Size of the shift depends on the size of the tax
• Best intervention is an indirect tax equal to the value of the externality - Shifts MPC to MSC
What is internalising the externality?
Increasing prices to reflect negative externalities
Which types of market failure can subsidies help to rectify?
• Cases where a product is under provided by a market
• Subsidies decrease the price, increasing demand and market output
What are subsidies?
Payments to producers to reduce the costs of production
How do subsidies effect positive externalities of production?
• The market output is less than the social optimum
• There is a deadweight loss of welfare
• Providing a subsidy for the product reduces the costs of production
• Shifts the MPC curve outwards
