Indirect Taxes & Subsidies

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The Impact of Indirect Taxes

Indirect taxes are taxes on consumption. The more inelastic demand is, the more of an indirect tax is passed on to consumers. Imposing a tax on a good, shifts the market equilibrium to Point A. At point A, there is a lower quantity of output and a higher price.

Burden of a tax

When a tax is imposed, the producer may pass on some of this cost to the consumer in the form of a higher price (grey area on the diagram) and absorb the rest (red area).
The proportion of the tax passed onto the consumer depends on the elasticity of demand. The more inelastic the demand, the more of a tax is passed on and less 'absorbed'.
E.g. demand for cigarettes is inelastic, producers would pass more of the tax onto consumers, knowing that demand won't decrease much.

Impact of indirect taxes on governments

Indirect taxes generate revenues for governments. These revenues can then be spent on capital investment (e.g hospitals for the NHS) or transfer (or welfare) payments.
If demand is perfectly inelastic, the quantity consumed won't change and tax revenues will increase. However, the burden of a tax would fall completely on consumers. If this was a market made up of mainly poor consumers, then this may not be a good intervention for the government. However, this would need a value judgment.

Impact of indirect taxes on consumers

If demand was perfectly inelastic, then the demand curve would be vertical.
The quantity demanded would not change but the price paid would rise.
The burden of the tax would fall completely on the consumer.
If demand was perfectly elastic (horizontal demand curve), then the burden would fall completely on the producer.

Impact of indirect taxes on producers

If demand is inelastic, then consumers bear the whole burden of an indirect tax.
If demand is elastic, then producers bear the whole burden of an indirect tax.

Subsidies

Subsidies can correct market failure by encouraging the consumption and production of a good with positive externalities. Governments can pay subsidies to encourage the production and consumption of goods.

Subsidies

Examples of subsidies

The employment of apprentices (labour as a factor of production) can be subsidised by a government.
A food subsidy was implemented in India to help encourage the production of affordable food in India.

The impact of a subsidy

A subsidy will shift the supply curve rightwards. The quantity produced will increase and the price paid by consumers will fall.
Consumers will pay 'Price _1+subsidy', but a supplier will be paid a 'Price ₂'.
The subsidy payment is the size of the rectangle. The size of the rectangle is equal to the size of the subsidy per unit X total output in the market.

Impact of subsidies on consumer and producer surplus

Consumers: Consumer surplus rises as the price that consumers pay has fallen and output has risen.
Producers: Producer surplus rises because the price consumers pay + subsidy is higher than the price at the previous market equilibrium.
Governments: Producer surplus and consumer surplus rise. However, the government must pay the size of the per unit subsidy X total output. Governments must pay for subsidies using tax revenues or government borrowing.