Indirect taxes and subsidies
Indirect taxes are those imposed by a government on goods and services, in contrast to direct taxes, such as income and corporation tax, which are levied on incomes of households and firms. Indirect taxes are also called expenditure taxes.
The purpose of indirect taxes is to:
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Generate tax revenue for a government
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Discourage consumption of ‘harmful’ products
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Encourage consumption of ‘good’ products
Specific and ad valorem taxes
There are two types of indirect tax; specific and ad valorem.
A unit tax is a set amount of tax per unit sold, such as a 10p tax on packets of cigarettes. In contrast, an ad valorem tax is a percentage tax based on the value added by the producer. Value Added Tax (VAT), currently at 17.5% in the UK, is the most important ad valorem tax. VAT was reduced to 15% in 2008 as part of the governments rescue package for the economy, but put back up to 17.5% in 2010. One advantage of ad valorem taxes is that the tax revenue to the government can rise automatically as the economy grows. This means that the tax rate does not need to be adjusted frequently, as in the case of specific unit taxes, such as duties on cigarettes and alcohol.
The imposition of either type of indirect tax has an effect similar to a rise in production costs. This means that a firm's supply curve will shift up vertically by the amount of the tax.
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A specific unit tax A specific unit tax will shift up the supply curve by the full amount of the tax, so that the new curve is parallel to the original one, as shown. |
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An ad valorem tax The imposition of an ad valorem tax will shift up the supply curve by a certain percentage, meaning that the new supply curve will not be parallel to the original. |
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An ad valorem tax |
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The incidence of a tax
The economic incidence, or burden, of a tax indicates the extent to which someone is made worse off by the tax. In contrast, the statutory incidence simply indicates who the law says will pay the tax. The economic and statutory incidence are often very different.
The incidence of a tax on cigarettes - an example
If the government puts an extra tax of 30p on each packet of cigarettes, the legal incidence is on the cigarette smoker. However, the local market may be very competitive, with many sellers, so that a retailer may fear they will suffer from lost sales, and decide to put up the price by only 20p, and pay the balance of 10p to the government themselves. In this case, the economic incidence is shared because both are worse off. The smoker is worse off because of the price increase of 20p, and the seller is worse off because 10p must come out of their revenue to pay the government.
The effect of price elasticity of demand
In most cases, the burden is split between producers and consumers and both parties are worse off. The key to whether the consumer or producer carries the burden is the extent to which the tax can be passed on to the consumer in terms of higher prices.
In the diagram below the incidence on the consumer is indicated by the price rise, P to P1, times the new quantity sold, 0 to Q1. However, the vertical distance is the tax per unit, which is greater than the price rise, hence the incidence on the producer is measured as the distance P to A, times 0 to Q1 - the blue shaded area. The precise division depends upon how consumers react to a price rise, that is, their price elasticity of demand.
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Tax burden evenly split The tax burden is split evenly between the consumer and producer. |
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Subsidies
A subsidy is an amount of money given directly to firms by the government to encourage production and consumption. A unit subsidy is a specific sum per unit produced which is given to the producer.
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Subsidies The effect of a specific per unit subsidy is to shift the supply curve vertically downwards by the amount of the subsidy. In this case the new supply curve will be parallel to the original. Depending on elasticity of demand, the effect is to reduce price and increase output. |
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The incidence of a subsidy
The economic incidence of a subsidy indicates who is made better off by the subsidy. In contrast, the legal incidence indicates who, by law, the subsidy is intended to help. In the diagram below, the subsidy per unit is A – B, and the new quantity consumed is Q1.
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Subsidies However, the price the consumer pays does not fall by the full amount of the subsidy – instead it falls from P to P1. Hence, although the intention of the subsidy may be to reduce the price to the consumer by the full amount of the subsidy, the producer gets some of the benefit in terms of extra revenue that they can keep. |
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The gain to the consumer is C – B per unit, and the whole gain to the consumer is the area PCBP1. The gain to the producer is C – A per unit and the total gain to the producer is PZAC. The overall cost of the subsidy to the government is the area, ZABP1.