Government Intervention: Indirect Taxation & Subsidies (AQA A Level Economics)

• An indirect tax is an expenditure tax that is paid when goods and services are purchased
• Indirect taxes are levied by the government to solve market failure 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, increasing the cost of production for firms
• Costs can be transferred on to consumers via higher prices
• Higher prices reduce quantity demanded (QD) and discourage the consumption of specific goods or services, for example demerit goods or products that generate negative externalities
  

Diagram: Impact of an Indirect Tax

An indirect tax is split between the consumer (A) and the producer (B)

Diagram analysis

• The initial equilibrium is at P₁Q₁
• The government places a specific tax on a demerit good
• The supply curve shifts upward from S₁→S₂ by the amount of the tax
  
  
• The new equilibrium is at P₂Q₂
• The price the consumer pays has increased from P₁ to P₂
• The price the producer receives has decreased from P₁ to P₃
• The government receives tax revenue = (P₂ - P₃₎ x Q₂
• Producers and consumers each pay a share or (incidence) of the tax
• The consumer incidence of the tax is equal to area A: (P₂ - P₁) x Q₂
• The producer incidence of the tax is equal to area B: (P₁ - P₃₎ x Q₂
  
  
• The final price is higher and QD is lower, resulting in a deadweight loss to society

Evaluating the use of Indirect Taxes 

Advantages	Disadvantages
Raises the price and reduces the quantity demanded of demerit goods Reduces external costs of consumption and production Raises revenue for government programs	The effectiveness of the tax in reducing the use of demerit goods depends on the price elasticity of demand (PED) Indirect taxes are often placed on price inelastic goods so QD may not fall very much It may lead to the creation of illegal markets as consumers seek to avoid paying the taxes Producers may be forced to lay off some workers as QD and output falls due to the higher prices

• A producer subsidy is a per unit amount of money given to a firm by the government
• Subsidies are used by governments to solve market failure by attempting to increase the output and consumption of specific goods or services, for example, merit goods
  • A subsidy reduces the costs of production and encourages an increase in the output of a good or service
  • Producers keep some of the subsidy and pass the rest on to consumers in the form of lower prices
  • Lower prices of a product encourage increased consumption
  • The distribution of the subsidy between producers and consumers is determined by the price elasticity of demand (PED) of the product

Diagram: Impact of a Subsidy

 

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

Evaluating the use of Subsidies

Advantages

Disadvantages

A subsidy increases demand for merit goods It lowers prices make goods more affordable to those on lower incomes reducing effects of poverty Can be targeted to helping specific domestic industries Helps to change destructive consumer behaviour over a longer period of time e.g. subsidising electric cars makes them affordable and helps motorists to see them as an option for the masses, not just the wealthy Can be used to help domestic firms compete internationally

It distorts the allocation of resources in markets E.g. it often results in excess supply when used in agricultural markets There is an opportunity cost associated with the government expenditure Subsidies are a disincentive for firms to become more efficient or competitive Subsidies are prone to political pressure and lobbying by powerful business interests E.g most oil companies receive subsidies from their respective governments (despite making substantial profits each year)