Indirect Taxes , Subsidies , and Price Controls

The effect of an indirect tax on the demand for, and supply of, a product

• Taxes and subsidies have and effect upon demand and supply and is influenced by relative price elasticities of the product.

Indirect taxes

• Indirect taxes are imposed on expenditure.

• It raises the firm’s costs and shifts the supply curve to the left.

• The vertical difference between two supply curve measures the tax amount.

Reasons for imposing taxes

The main reasons for government imposing taxes can be

To generate Government revenues: excise duties on beers, wines and spirits are price inelastic in demand, so tax price increases by levying specific alcohol and tobacco taxes raise consumer expenditures as a whole on these categories and therefore taxation revenues;

To discourage consumption: Government might use taxes to discourage consumption of certain demerit goods such as cigarettes.

To alter the pattern of consumption: Government might use direct taxes as a mean to alter the consumption patter of its population. Certain goods can be made more price attractive through lower taxes while goods which have high marginal social cost can be made expensive through taxation.

Two types of Indirect Taxes

• A specific tax: It is a fixed amount of tax imposed upon a product

Two types of Indirect Taxes

• A percentage tax(Ad valorem tax): This is a tax imposed as a percentage of the selling price.

• As the price increase, the tax amount also will be bigger.

Distinction between specific and ad valorem taxes

Specific tax is a flat rate of tax whereas ad valorem tax is a percentage tax.

Ad valorem literally the term means “according to value.” It is imposed on the basis of the monetary value of the taxed item.

A specific tax is when specific amount is imposed upon a good, for example $10 on each mobile phone sold; whereas ad valorem tax is expressed as a percentage of the selling price e.g. 12% of the sales.

The amount of specific tax changes in the same proportion as the quantity sold increase, whereas, in ad valorem the tax collected is more at higher prices then at lower prices.

Producer revenue

S1+TaxProducer revenue before tax

Producer revenue after tax

P2

P1PeC

W

X

Y

What will happen to the price that the consumer pay?

What will happen to the amount received by the producer

Government tax revenue and tax burden

Share of tax burden for consumers and producers.

• Incidence of an indirect tax on consumers and producers is greatly influenced by the PED and PES of the commodity.

• Situation 1: PED PES.

Share of tax burden for consumers and producers.

• Situation 2: PES PED

Rules in Incidence of Indirect Tax

• 1. PED = PES Burden equally shared between consumers and producers.

• 2.PED > PES Burden more on producers than on consumers.

• 3. PED < PES Burden more on consumers than on producers.

The effect of a subsidy on the demand for, and supply of, a product

• A subsidy is an amount of money paid by the government to producers or consumers per unit of output.

• A subsidy has an opposite effect of a tax.

• Subsidies may be regarded as negative indirect taxes.

Reasons for Subsidies

• To lower the price essential goods. Encouraged by lower price, consumption will be increased.

• To guarantee the supply of products that the govt thinks are necessary for the economy.

• To enable producers to compete with overseas trade and to protect the home industry.

How is it helping?

• When subsidy is granted, supply curve will shift vertically downwards by the amount of the subsidy.

• It lowers the prices.• This is again depended

on the relative elasticities of demand and supply.

Specific subsidies and percentage subsidies

• A specific subsidy is a specific amount of money that is given for each unit of the product. (eg:$3 per unit)

• A percentage subsidy is fixed on the basis of the price of the product. As the price increases, amount of subsidy also increase.

• But this is very rare in practice.

Increase in producer revenue• The market is in equilibrium

at Qe.• When a subsidy of WZ per

unit is granted, supply curve shifted from S to S-Subsidy .

• Producer lowers the price and increase the output till the new equilibrium is reached at P1 price and Q1 quantity demanded and supplied.

• Income of producer rises from OPeXQe to ODWQ1

Influence of subsidies on consumer expenditure

• Subsidies always makes the consumer able to spend more.

• In the diagram, as price decreased from Pe to P1, the consumption expenditure increased by QeQ1 {PED is elastic}

Influence of subsidies on consumer expenditure

• In the diagram, as price decreased from Pe to P1, the consumption expenditure increased by QeQ1 {PED is inelastic}

Cost of subsidy to the governement

• The total cost for the government is the shaded area on the diagram[P1DWZ]

• This money has to be taken away from other areas or it must raise the taxes.

Cautions/Pre-cautions while granting subsidies

• The opportunity cost involved.• Whether subsidy will allow

firms to be inefficient.• Subsidies are ultimately

funded by tax payer. Who is paying the taxes?

• Whether it is causing any damages to the foreign producers who are not receiving subsidies?

Price Controls

• The free market does not always lead to the best outcomes for all producers and customers, or for society. So the govt. intervention is necessary.

• The main two interventions are through:• Maximum prices and • Minimum prices.

Maximum(low) price controlsThis is a situation where the government sets a maximum price, below the equilibrium price.This prevents producers from raising the price above it.This is also known as the ceiling price.Normally imposed when the good is a necessity and /or a merit good.

• Excess demand leads to black market.

• The shortage of goods needs to be eliminated.

• Two options:• 1. Shift the demand curve to the

left.(Not a good move!)• 2. Shift the supply curve to the

right. This can be done through:• (a) Offer subsidies to encourage

production.• (b) Govt directly producing goods.• (c ) Release the old stock.

Minimum(high) price controls

• This is a situation where govt. sets a minimum price, above the equilibrium price.

• This prevents producers from reducing the price below it.

• This is also known as floor prices.

Why minimum price?

• To raise incomes for producers of goods and service that the govt. thinks are important.(large fluctuations in price or lot of foreign competition)

• Setting minimum wages helps the workers earn a reasonable income.

Maintaining minimum price through govt. intervention

• The govt. can eliminate the excess supply by buying up the excess products at the minimum price and thus can shift the demand curve to the right

What the government will do with this?

• But the govt. has to either store it or destroy it; both are expensive

• Can sell outside?....will lead to angry reactions from foreign govts. for dumping.

Maintaining minimum price through govt. intervention

• Quota: Producers could be limited by quotas.

• It restricts the supply at Q1(as per the diagram)

• It would keep price at Min P

Quota

Maintaining minimum price through govt. intervention

• Govt. could attempt to increase demand for the product by advertising or by restricting supplies from abroad through protectionist policies.

• But if the governments protect firms by guaranteeing minimum prices,

• Firms will become less cost-conscious and may lead to inefficiency.