Taxes and Subsidies

Taxes
A tax is a compulsory monetary contribution imposed by the government upon individuals,
corporations and other money making establishments without rendering any service in return.
A tax involves imposing compulsory contribution on the private sector to meet the expenses which
are incurred for a common good, that is, transfer payment process from the private sector (including
the public) to the government with a view to financing public expenditure (such as provision of
public and merit goods).

What is the definition of a 'good' tax?

In the book "The Wealth of Nations" by Adam Smith, he discusses the 'cannons' of taxation. These
are characteristics that all good taxes should have:
1. Fairness. A tax should always consider the taxpayers' 'ability to pay'.
2. Cost. The cost of collection (for the government) should not be too high. In particular, the cost
should be a relatively small proportion of the tax yield.
3. Convenience. It should be as easy as possible for the taxpayer to pay the tax (in terms of means
and timing of payment). Note that the Pay As You Earn (PAYE) method of tax collection on most
peoples' income is a good example.
4. Certainty. The timing, method and amount due should be absolutely clear. There should be no
excuses for tax evaders.
5. Flexibility. The tax should be capable of being changed to meet changes in economic conditions.
6. Efficiency. The tax should not reduce economic efficiency but increase it
Average and marginal rates of taxation
Average rates of taxation refer to the average percentage of total income which is paid in taxes. This
form of taxation can also be referred to as the average propensity to pay tax.
APT= Tax
Income
Marginal rates of taxation, on the other hand, refer to the proportion of an increase in income which
is taken in tax.
MRT = Change in tax
Change in income
Proportional, progressive and regressive taxes
These terms are important when assessing whether a tax is fair or unfair. They are important
concepts to understand as they relate to whether or not a tax is redistributive or not.
Progressive taxes
A progressive tax is one where, as one's income rises, one pays more tax as a percentage of one's
income. Marginal rate of tax (% of tax) increases with income. Most direct taxes like income tax are
progressive.
Regressive taxes
A regressive tax is one where, as one's income rises, the amount that is paid as a percentage of one's
income falls. The Marginal rate of tax (% of tax) decreases with income. Notice, though, that a higher
earner may be paying more of the tax in absolute terms, but as a percentage of their income, the
amount is falling. These taxes are, obviously, considered to be unfair as they redistribute money
from the poor to the rich (in relative terms). Most indirect taxes are regressive.
Proportional taxes
A proportional tax is one where, as one's income rises, one pays more tax, but the amount that is
paid as percentage of one's income remains unchanged. Marginal rate of tax (% of tax) remains
unchanged as income changes. Example if a the tax is set at 30% of income, then higher earners
would pay more tax than low earners, but the amount they pay expressed as a percentage of their
income would always remain the same (i.e. 30%). Someone earning $50,000 a year would pay
$15,000 income tax, and someone on $10,000 a year would pay $3,000 tax. The high earner is
paying much more tax, but in both cases, the amount paid is exactly 30% of one's income. Some
economists argue that VAT is a broadly proportional tax. As one gets richer, one will spend more
money and the tax percentage remains roughly the same.
Direct taxes and indirect taxes
Direct Taxes
Direct taxes are imposed on income, being directly paid by the tax payers to the government.
Income tax is an example of a direct tax. Increase in direct taxes reduces the disposable income and
hence, the demand for normal goods. It is shown by a leftward shift in the demand curve.
Indirect Taxes
Indirect taxes are imposed on expenditures, being indirectly paid by the tax payers to the
government. Sales tax, value added tax (VAT), excise and custom duties are examples of indirect
taxes. Consumers are made to pay them indirectly to the government when producers include these
taxes in the price of products. Indirect taxes shift the supply curve upwards (leftwards) and cause a
movement along the demand curve.
Specific tax and ad valorem tax
Specific tax:

An indirect tax that is a fixed amount per unit of output. The amount of tax does not change with the
price/value of the product e.g. a tax of $0.5/unit. Such a tax shifts supply curve upwards in a parallel
fashion, as shown in the diagram. In case of specific tax, the vertical distance between two supply
curves i.e. the tax amount per unit is constant throughout.

Ad valorem tax (percentage tax)

Ad valorem tax is one, the amount per unit of which varies directly with the price/value of the
product (a tax that is charged as a given percentage of the price) e.g. a sale tax of 5% of the value of
the product. Such a tax shifts supply curve upwards and as shown in the diagram, the vertical
distance between two supply curves (indicated by the red arrows) keeps on increasing with the
value of the product.
Incidence of taxation
The incidence of taxation is who finally pays the tax. Taxes and subsidies affect the supply curve.
Taxes are designed to limit production of a good. The increase in cost shifts the supply curve to the
left.
Tax incidence and elasticity
The greater the PED or the smaller the PES, the greater the burden upon producers. It is mainly
goods with an inelastic demand which are taxed; this ensures that the bulk of the incidence of
taxation is passed on to the consumer.
Distribution of indirect taxes and price elasticity of demand
Producers successfully transfer a higher portion of tax to consumers by raising prices, if the price
elasticity of demand is low. In Fig. 11.4, a relatively steep demand curve showing price inelastic
demand is drawn. In this case, consumer burden, ABCD is greater than producer burden, DCFE. Fig.
11.5 shows a relatively flat demand curve, making consumer burden, ABCD smaller than producer
burden, DCFE.

Distribution of indirect taxes and price elasticity of supply

Producers successfully transfer a higher portion of tax to consumers by raising prices, if the price
elasticity of supply is high. Fig. 11.6 shows a relatively steep supply curve which causes consumer
burden, ABCD to be smaller than producer burden, DCFE. In Fig. 11.7, the supply curve is relatively
flat and consumer burden, ABCD is greater than producer burden, DCFE.

Consumers bear the entire tax burden, if the price increases exactly by the amount of tax. This can
happen when:
(i) price elasticity of demand is zero (demand is perfectly inelastic)
(ii) price elasticity of supply is infinity (supply is perfectly elastic)
Producers bear the entire tax burden (EFGH) if the price remains unchanged even after the
imposition of a tax. This can happen when:
(i) price elasticity of demand is infinity (demand is perfectly elastic)
(ii) price elasticity of supply is zero (supply is perfectly inelastic)

Demand Supply Tax incidence

Elastic Inelastic Greater tax burden on suppliers
Inelastic Elastic Greater tax burden on consumers
Perfectly elastic - Whole tax burden on suppliers
Perfectly inelastic - Whole tax burden on consumers
- Perfectly elastic Whole tax burden on consumers
- Perfectly inelastic Whole tax burden on suppliers

Subsidies
Subsidies are government grants paid to producers to encourage increased production of certain
goods or services, such as merit goods. By reducing the price of specific goods or services, the
government is also attempting to increase their consumption. Subsidies can also be used to promote
the use of products which reduce external costs, such as public transport. Granting a government
subsidy has the effect of shifting the supply curve to the right.

Subsidies act in the opposite way to taxes. They encourage greater production of a good, shifting the
supply curve to the right. It is mainly goods with elastic PEDs which are subsidised as this ensures
most of the cost saving is passed on to the producer.
Subsidies are negative taxes and their imposition shifts supply curve downwards by the subsidy per
unit. Subsidies are of two types:
Specific subsidy Ad valorem subsidy
Specific subsidy
A specific subsidy is one, the amount of which does not change with the price/value of the product
e.g. a subsidy of $0.5/unit. Such a subsidy causes a parallel, downward shift in the supply curve, as
shown Fig. 11.12. S0 is the original supply curve and S1, the supply curve after subsidy. In case of
specific subsidy, the vertical distance between two supply curves i.e. the subsidy per unit is constant
throughout.
Ad valorem subsidy (percentage subsidy)
Ad valorem subsidy is one, the amount/unit of which varies directly with the price/value of the
product e.g. a subsidy of 5% of the value of the product. Ad valorem subsidy shifts the supply curve
downwards too, but the vertical distance between the two supply curves rises continuously with the
value of the product, as shown in Fig. 11.13.
Distribution of subsidies between consumers and producers
Producers usually try to keep the benefit of subsidy to themselves but their ability to keep prices
unchanged depends upon the price elasticities of demand and supply.
Subsidies usually reduce prices but prices remain unchanged when price demand is perfectly elastic
diagram or when supply is perfectly inelastic diagram. In these two cases, the entire benefit of the
subsidy goes to producers. Subsidies usually increase quantity traded but it doesn’t change when
demand is perfectly inelastic diagram or when supply is perfectly inelastic diagram. Consumers enjoy
the entire subsidy benefits, if price reduces exactly by the amount of subsidy i.e. when either
demand is perfectly inelastic diagram or when supply is perfectly elastic diagram.

Demand Supply Tax incidence

Elastic Inelastic Greater subsidy benefit to suppliers
Inelastic Elastic Greater subsidy benefit to consumers
Perfectly elastic - Whole subsidy benefit to suppliers
Perfectly inelastic - Whole subsidy benefit to consumers
- Perfectly elastic Whole subsidy benefit to consumers
- Perfectly inelastic Whole subsidy benefit to suppliers

Advantages of using subsidies

• Subsidies on merit goods can increase their consumption, bringing the equilibrium quantity closer
to the social optimum, helping to internalise the external benefit.
• Subsidies reduce the price of a good, making it more affordable for those on lower incomes, so
reducing the effects of relative poverty.
Disadvantages of using subsidies
• As in the case of taxing negative externalities, it is extremely difficult in practice to place an
accurate monetary value on the size of external benefits.
• Funding for subsidies carries an opportunity cost, i.e. the money could have been spent on other
things such as building new hospitals or roads.
• Firms receiving subsidies may become reliant on them, encouraging productive inefficiency and
laziness, and reducing international competitiveness in the long run.
• Subsidies for UK firms may be viewed by foreign governments as a form of artificial trade
protection, encouraging them to retaliate by erecting their own forms of protection.
• If subsidies are placed on goods or services with inelastic demand, they may reduce price but not
significantly increase consumption.