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Impact of indirect taxes
Indirect tax is payment collected by firms and paid to government.
An example is the UK Government’s tax (“duty”) on cigarettes.
An indirect tax shifts supply left from S to S+tax. The vertical distance between the two supply curves represents the size of the tax.
As a result, the price rises from p to p1 and quantity falls from q to q1.
Welfare analysis of an indirect tax
The diagram below breaks down the effect of the indirect tax on different groups:
- Consumer surplus falls because of the tax.
- Consumers face higher prices and consume less.
- Producer surplus falls.
- While the market price is higher, the price that producers actually receive per unit sold has fallen from p to p2. Producers are also selling less.
- Government does gain tax revenue.
- The tax revenue is equal to the tax per unit (the difference between p1 and p2), multiplied by the number of units sold q1.
- When we sum up the changes in surpluses and revenue, we find an overall welfare loss of area EFG.
Other effects of an indirect tax
In addition to the effects on consumer surplus and producer surplus, there may be other effects from indirect taxes.
- Producers may experience:
- A fall in revenue and profit. This leads to reduced firm investment in improving product quality.
- Reduced employment. The firm may not be able to afford to keep on all its workers.
- Greater likelihood of the firm shutting down.
- Possibly switch to producing non-taxed goods. For example if petrol cars are taxed, firms may switch to producing electric cars.
- Consumers may experience:
- The quality of the product may deteriorate as firms have reduced funds to invest in improving quality.
- Possibly switch to consuming substitute goods that do not face the tax. For example, if sugary drinks are taxed, consumers may switch towards sugary foods or non-sugary drinks.
- Particularly where the good has a price-inelastic demand, inequality may rise. The tax is likely to take up a greater percentage of the income of a low-income consumer, compared to a high-income household.
The analysis on this page assumes there is no initial market failure, before the tax is put in place.
Consider a situation where there is a market failure, such as a negative externality from pollution. In this case, a tax may increase overall welfare and have positive effects on those suffering the consequences of pollution. This will be covered more in notes on unit 1.4.
Incidence of indirect taxes
The incidence of a tax is the burden of the tax – it shows who actually pays the tax.
Below the diagram shows the incidence of the tax. Again the tax shifts supply left, this time from S to S1.
The tax revenue is split into two components:
- First the consumer incidence.
- Consumers indirectly pay for the tax through higher prices.
- The price consumers pay has risen from p to p1.
- The red area represents the consumer incidence – how much of the tax revenue the consumer is (indirectly) paying.
- Second the producer incidence.
- Producers can only shift part of the burden of the tax onto consumers with higher prices. The producers face the remaining tax burden.
- This effectively means the price per unit that producers receive falls from p to p2.
- The blue area is the producer incidence.
- In this particular example, the producer incidence is greater than the consumer incidence.
- In other words, the producer faces most of the tax burden and cannot pass much of the tax onto consumers.
How elasticities influence the effect of the indirect tax
Suppose the price elasticity of demand (PED) is inelastic. This may occur with addictive goods, like alcohol.
How would inelastic PED change the effect of an indirect tax (compared to elastic PED)?
- The price rises to a greater extent, while the quantity falls by less.
- So any impacts on inequality from the tax are likely to be greater – more people facing a greater price rise.
- Because the tax has mostly been pushed onto consumers, consumer surplus falls to a greater extent. Meanwhile, producer surplus falls to a lesser extent.
- As the quantity falls by less, the overall welfare loss from the tax is smaller.
- There is a greater consumer incidence of the tax.
- With an inelastic PED, consumers cannot easily switch to substitute goods nor reduce their demand.
- Firms can take advantage of this and push most of the tax onto consumers by raising prices.
- So the producer incidence of the tax will be smaller.
A similar point applies with the price elasticity of supply (PES).
If the PES is inelastic, then producers cannot reduce production easily to reduce their tax burden. So there is a greater producer incidence.
Also if the PES is inelastic, the quantity will fall by less as a result of a tax. This is compared to an elastic PES.
Impact of subsidies
Subsidy is a payment to firms by government.
For example the UK Government pays steel producers to increase (or maintain) steel production.
A subsidy lowers firm costs and shifts supply right.
This results in a price fall from p to p1. The quantity rises from q to q1.
Welfare analysis of a subsidy
Suppose the government subsidises a market, where there is no market failure.
In this scenario, a subsidy causes a welfare loss of area BEF.
Why is the welfare loss BEF?
The government spending on the subsidy exceeds the rise in consumer surplus and producer surplus.
Specifically for consumer surplus (CS):
- Without the subsidy, CS is area ABp.
- With the subsidy, CS rises to AFp1.
- Consumers consume more for a lower price.
- So CS rises by area pBFp1.
As for producer surplus (PS):
- Without the subsidy, PS is pBC.
- With the subsidy, PS increases to p2EC. The producer sells more for a higher price.
- Note we use the original supply curve S to measure producer surplus – this makes comparing PS before and after the subsidy much easier.
- Note that while the subsidy lowers the market price from p to p1, the firm receives the market price (p1) plus the subsidy (vertical distance between the supply curves) for each unit sold. So the firm effectively receives p2 revenue per unit sold.
- The increase in PS is p2EBp.
However the government loses money from the spending on the subsidy. The total spending on the subsidy is p2EFp1.
Add up the CS gain, PS gain. Then subtract the government spending. This gives a welfare loss of BEF.
Other effects of subsidies on consumers and producers
Consumers:
- As firms may invest more into improving product quality, consumers may benefit from higher quality product.
- Consumers may reduce demand for substitutes to the subsidised goods. This is because the substitute goods are now comparatively more expensive.
Producers:
- Higher profits for firms may lead to greater investment into improving product quality.
- The firm may grow in size, allowing the firm to take advantage of economies of scale.
- A higher equilibrium quantity leads to higher demand for labour, boosting the level of employment.
- Firms are more likely to survive and less likely to shut down.
Dividing subsidy into producer and consumer areas
We can divide up the subsidy funds into the amount that goes to the producer and the amount going (indirectly) to the consumer.
This is similar to how the tax revenue can be split up into the producer incidence and the consumer incidence.
The producer gets higher revenue per unit produced from p to p2 in the diagram below. As a result, part of the subsidy expenditure (blue area) benefits producers. This is called the “producer subsidy“.
At the same time, the consumer experiences a fall in price from p to p1 in the diagram below. So part of the subsidy expenditure (red area) is passed onto consumers in the form of lower prices. This is called the “consumer subsidy“.
Note that the relative sizes of the producer and consumer subsidy depend on elasticities.
Whichever party is less responsive to price changes generally experiences the greater subsidy.
- For example, suppose the PED is inelastic and the PES elastic. Then the consumer subsidy is larger than the producer subsidy.
- Suppose instead the PED is elastic and the PES inelastic. Then the producer subsidy is larger than the consumer subsidy.
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