Application of Demand and Supply - Taxes and Subsidies

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Tax: Money payed to the government by firms

Types of Tax

1. Direct tax
   1. Income/wealth tax
      1. Paid by households or firms directly to the government
      2. Personal income tax
      3. Corporate tax
2. Indirect tax
   1. Tax on Goods/Services
      1. Paid indirectly to the government via the sellers of the good
      2. Taxed on profit, not revenue
   2. Specific tax
   3. Ad valorem tax
      1. Example is General Sales Tax (GST)

Indirect Tax

• Shifts the supply curve up by the amount of tax imposed

Specific Tax

• Good or service is taxed a fixed amount per unit
  • e.g. $5 per kg
• Hence, tax per unit of the good is the same regardless the price of the good
• Specific tax imposes a parallel shift (of the supply curve) upwards by the full amount of the tax

Ad Valorem Tax*

• Good or service is taxed a percentage based on the value of the product
  • e.g. 7% GST
• Hence, the higher the price of the good, the higher the tax per unit of the good will be
• Pivots the supply curve upwards, i.e. skewed upwards

Taxes on a demand and supply curve only affects the supply curve

Effects of Taxation

1. Impact of a tax
   1. Falls on the person on whom the tax is first levied
   2. i.e., seller gets it first
2. Incidence******* of a tax
   1. Refers to the eventual distribution of the tax burden (i.e., who ultimately bears the tax)

Example:*

1. Government levies tax on producer
2. Impact of tax is on producer
3. Incidence of tax is shared between producer and consumer

Effects

1. Increases cost of production
2. Decreases supply
3. Shortage at $P_0$
4. Increases Equilibrium Price
5. Decreases Equilibrium Quantity
6. Affects Consumption

When graphing Consumer/Producer Surplus: Always use original supply curve to calculate, not the new supply curve (with tax)

Incidence of Taxation

Who bears a heavier tax burden

• Depends on the relative price elasticities of demand and supply
• The more price inelastic the demand is, the greater the burden of tax on buyers
• The more price inelastic the supply is, the greater the burden of tax on sellers
• In general, the party that is relatively less responsive to price changes will bear a higher burden of the tax

Subsidies

• Payment of money to firms by the government for the purpose of reducing cost of production and increasing production
• No exchange of goods or services in return
• Sometimes known as negative taxes
• Why do governments give subsidies?
  • Microeconomic objectives
    • Protect incomes of farmers
    • Encourage production or consumption of merit goods
  • Macroeconomic objectives
    • Encourage research and development
• Justifying Subsidies
  • Form of government intervention
  • Introduced for a number of economic, social and political reasons

Imposition/Effect of Subsidy

• Supply curve shifts downwards by the full amount of the subsidy
• Total subsidy: $P_1{P}_2\times 0Q_1$
• Consumers get: $P_1{P}_0\times 0Q_1$
• Producers get: $P_0{P}_2\ast 0Q_1$