Government Intervention: Indirect Taxes & Subsidies (DP IB Economics)

Indirect Taxes

• 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
    

• Indirect taxes are levied by the government on producers. This is why the supply curve shifts 
   

• An indirect tax can be either ad valorem or specific
   

1. A Specific Tax

• A specific tax is a fixed tax per unit of output (specific amount) e.g. $3.25/packet of cigarettes

The impact of an indirect tax is split between the consumer (A) and the producer (B)
 

 Diagram Analysis

• Initial equilibrium is at P₁Q₁

• 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

• Producers and consumers each pay a share (incidence) of the tax

  • 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

• New equilibrium is at P₂Q₂

  • Final price is higher (P₂) and QD is lower (Q₂)

  • If the decrease in QD is significant enough, it may force producers to lay off some workers

2. Ad Valorem Tax

• A tax that is a percentage of the purchase price e.g. Value added tax (VAT) in Columbia in 2022 was 19%

  • The more goods/services consumed, the larger the tax bill

  • This causes the second supply curve to diverge from the original supply curve

  • VAT raises significant government revenue

A diagram showing an ad valorem tax (VAT) and the tax incidence for producers and consumers
  

Diagram Analysis

• Initial equilibrium is at P₁Q₁

• The government places an ad valorem tax to raise government revenue

  • Supply shifts left due to the tax from S → S + tax

    • The two supply curves diverge as a percentage tax means more tax is paid at higher prices

• 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

• Producers and consumers each pay a share (incidence) of the tax

  • 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

• New equilibrium is at P₂Q₂

  • Final price of goods/service is higher (P₂) and QD is lower (Q₂)

  • If the decrease in QD is significant enough, it may force producers to lay off some workers

An Evaluation of Indirect Taxes

The Advantages and Disadvantages of Indirect Taxes

A side by side Comparison of the Impact of PED on Tax Incidence

• Aiming to maximise their profits, producers pass on as much of the indirect tax as they can to consumers and pay the balance themselves

• The amount passed on to consumers depends on the price elasticity of demand (PED) of the product

A diagram that demonstrates the tax incidence for a product whose PED is inelastic (left) and elastic (right). A is the consumer incidence and B is the producer incidence
  

Diagram Analysis

1. 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
      

2. For an inelastic product (e.g. cigarettes)
   

   • The curve is steep

   • 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)
      

3. For an elastic product (e.g. pizza)
   

   • The curve is much flatter

   • 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)

Subsidies

• A producer subsidy is a per unit amount of money given to a firm by the government

  • To increase production

  • To increase the provision of a merit good
    

• The way a subsidy is shared between producers and consumers is determined by the price elasticity of demand (PED) of the product
  

  • Producers keep some of the subsidy and pass the rest on to the consumers in the form of lower prices

A diagram which demonstrates the cost of a subsidy to the government (A+B) and the share received by the consumer (A) and producer (B)

Diagram Analysis

• 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 share of the subsidy is marked B in the diagram

• The subsidy decreases the price that consumers pay from P₁ → P₂

  • Consumer share 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  

An Evaluation of Subsidies

The Advantages and Disadvantages of Producer Subsidies