Reasons for intervention, indirect taxes and subsidies

Last time

Before we start: last time, in Measuring and addressing inequality, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Why and how governments step in

Markets fail in many ways, so governments intervene. Two common tools are indirect taxes and subsidies. This lesson covers the reasons for intervention, and the effects of taxes and subsidies, including who really pays.

Reasons for intervention

To correct market failure: public goods, merit and demerit goods, and externalities. To reduce inequality in income and wealth. To control monopoly power, stabilise prices, and raise revenue.

Indirect taxes

An indirect tax is a tax on spending, paid by the seller to the government. A specific tax is a fixed amount per unit; an ad valorem tax is a percentage of the price, such as a sales tax. It raises costs, so supply shifts left, or upwards by the amount of the tax.

A specific tax

A tax of 2 dollars a unit shifts supply from S to S1. The price rises from 5 to 6 dollars and quantity falls from 5 to 4. Consumers pay 1 dollar more; producers receive 1 dollar less: the burden is shared. Tax revenue is 2 times 4: 8 dollars.

Tax incidence and PED

The incidence of a tax is how its burden is shared between consumers and producers. If demand is price inelastic, consumers bear most of the tax, as the price rises by most of the tax. If demand is elastic, producers bear more, as they cannot pass it on.

Subsidies

A subsidy is a payment by the government to producers, which lowers their costs. Supply shifts right. With a 2 dollar subsidy, price falls from 5 to 4 and quantity rises from 5 to 6. The cost to the government is 2 times 6: 12 dollars. Consumers and producers share the benefit.

Taxes versus information

A tax raises the price, so consumption falls, especially if demand is elastic. An information campaign reduces demand by correcting information failure, shifting demand left. For addictive goods with inelastic demand, a tax raises revenue but cuts consumption little; information may change habits in the long run.

Evaluating taxes and subsidies

Taxes are regressive if they take a larger share of poorer people's income. It is hard to set the right level, as external costs and benefits are hard to measure. Subsidies have an opportunity cost and may make firms inefficient. These are risks of government failure.

Supporting merit goods

Governments support merit goods such as education and health care with subsidies or direct provision. This raises consumption towards the socially optimal level, and helps the poor. But it costs taxpayers, may cause overuse, and the quality of state provision varies. Judge whether the benefits outweigh the costs.

Mistakes that lose marks

Mistake one: shifting demand for an indirect tax. It shifts supply. Mistake two: saying consumers pay all of a tax. Mistake three: no evaluation of government failure. The fix: supply shifts, incidence by PED, and government failure.

The full-marks tip

The full-marks tip: draw the tax as a vertical shift of supply by the tax per unit, and show the new price and quantity. Explain incidence using PED, and evaluate with government failure.

On one card

So, on one card: taxes and subsidies. Keep it for revision.