1.2.9 Indirect taxes and subsidies

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    a) Supply and demand analysis, elasticities, and:
    The impact of indirect taxes on consumers, producers and government and The incidence of indirect taxes on consumers and producers
    Introduction of a tax increases the cost of production and thus shifts the supply curve inwards (S1 – S2), leading to an increase in price (P1 – P2) and a fall in quantity demanded and supplied (Q1 – Q2)
    The tax internalises the externality (the producer pays) – this makes an external good of an internal good.

    Burden of indirect tax falls differently on consumers and firms – depends on if the good has an elastic or inelastic demand
    Indirect taxes – very effective at raising (government) revenue when demand is price inelastic
    But the more price inelastic demand is – less effective an indirect tax will be in reducing use of the good
    Important – taxes shift the supply curve, not the demand curve
    If a firm sells an inelastic good they are likely to put most of the tax burden on the consumer, because they know a price increase will not cause demand to fall significantly
    True of goods with few or no substitutes – habitual goods (addictive drugs) and where the good forms a relatively small proportion of overall spending

    The tax revenue generated is greater when demand is price inelastic – because the firm is able to pass on far more of the tax to the consumer without seeing a large drop in sales.
    Not as effective for raising government revenue, but if a government wants to reduce the demand of a particular good, it is effective. Demand will fall significantly, from Q1 to Q2

    Elasticity of demand and subsidies
    Subsidy – A payment from government to firms to encourage production of a good and to lower their average costs
    Has the opposite effect of a tax – increases supply
    Benefit of subsidy can go to the producer (increased revenue (C-P1)) or to the consumer (lower prices (P1-P2))
    Taxation: Point of Evaluation
    PED determines how much the consumer or producer pays
    More price elastic goods – taxes are less effective as the producer can pass on cost to consumer
    Perfectly elastic demand – burden of indirect tax falls entirely on the producer
    Perfectly inelastic demand – burden of tax falls entirely on the consumer
    Indirect taxes are regressive and hit lowest income individuals hardest and thus income inequality

    The area that represents the producer subsidy and consumer subsidy
    Subsidy – A payment (or grant) from government to firms to encourage (promote) production of a good and to lower their average costs (usually a merit good)
    Has the opposite effect of a tax – increases supply

     

     

     

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