Taxes and Subsidies
Taxes are defined as a levy placed on consumers or producers by a government organisation in order to raise revenue. When the burden of tax has the ability to be passed from producers to consumers it is known as indirect tax. This can be in the form of specific tax (a set amount) or ad valorem tax (a percentage of the value of the good or service.)
The Effects of Tax
As demonstrated on the model above, taxes are shown by upwards shifts in the supply curve, equivalent to the value of the tax. How this affects the equilibrium depends on the elasticity of the product.
If the product is price inelastic, then there will be a large increase in the price of the good as producers know this will not decrease sales. This means that consumers carry the burden of tax for price inelastic goods. This is shown by the purple shaded square on the model, as it demonstrates the decreased consumer surplus as the price of the good rises. Comparatively, the smaller green square shows the decreased producer surplus, demonstrated how the tax mainly impacts consumers. However, this will only cause a small decrease in the quantity demanded as the good is price inelastic.
If products are price elastic, then there will be a small increase in the price of the good meaning that producers carry most of the incidence. This is because an increase in price will cause a decrease in sales. However, the effect of the tax will cause a large fall in the quantity demanded.
A subsidy can be defined as a payment from the government to a firm that incentives productivity or output of a good or service. This occurs to promote the production of a good with a positive benefit to society such as positive externalities, promoting local produce as opposed to imports or building employment in that industry.
The Effects of Subsidies
As shown by the models above, subsidies cause the supply curve to shift downwards by the equivalent amount of the subsidy. The level of price elasticity of the good or service will determine the effectiveness of the subsidy and who benefits from it the most.
If a product is price inelastic, then there will be a large decrease in the price of the product, meaning that the benefit of the subsidy is greatly passed onto consumers. This is shown by the size of the shaded blue square, demonstrating how the decrease in price is translated directly to the selling price of the product, therefore benefitting consumersd.This means that they pay a lower price for the same good. Furthermore, the model shows that size of the tax is the rectangle area marked by the blue lines.
If the product is price elastic, there will be a small decrease in the price of the product but they purchase more goods, meaning that producers gain the most benefit from the subsidy on an elastic good, as production costs are lowered, there is only a small decrease in price and a large increase in quantity demanded. On both models the increase in producer surplus is shown by the shaded green boxes.
How Do Taxes and Subsidies Affect Market Efficiency?
In a normal market, the presence of taxes and subsidies will reduce market efficiency and cause a deadweight loss. This can be seen on the models above as 'DWL'. However, if there are externalities present in the market, the addition of taxes or subsidies can increase or correct market efficiency and bring the equilibrium to an efficient point.
Taxes can reduce the inefficiencies of negative externalities, as they increase the price for producers or consumers, in turn, correcting over-consumption or over-production. Comparatively, subsidies reduce the price for producers to make the product or for consumers to purchase it, therefore, it increases production or consumption of a positive externality which would otherwise be under-consumed and under-produced.