Government Intervention -Taxes and Subsidies
Taxes, which are placed on goods and services, are known as indirect taxes, as opposed to direct taxes which are placed on income and wealth. When a tax such as VAT is levied on a product it has the same economic effects as an increase in the costs of production. In terms of supply and demand, the imposition of a tax may be seen as a fall in supply.
Where demand for a good is elastic the government will receive relatively little revenue from the tax. This is because of a large fall in demand. The majority of the tax will be borne by the producers as the rise in price for consumers is only small
Where demand for the good being taxed is inelastic the ...view middle of the document...
Two main reasons for a government placing a tax on a good or service is to:
▪ Raise Revenue
▪ Discourage consumption or production.
This is an example of an indirect tax. A tax that is a percentage of the selling price. An example of an ad valorem tax would be VAT, and taxes on petrol, cigarettes and alcohol.
An ad-valorem tax is a percentage tax on a good. This means that the supply curve will shift by varying amounts. At the lower end of the price range the amount of the tax will be less than at the higher end of the price range and so the supply curve shifts at an angle. It will shift the supply curve vertically upwards by the amount of the tax. Here that has led to an increase in price to P2 and a decrease in output to Q2.
Subsidies may be regarded as negative taxes. They normally take the form of payments by the government to producers. The effect of a subsidy is to reduce the costs of supplying a product. A subsidy will cause an outward shift in supply – now more is supplied at any given market price. Price will fall and the quantity demanded will increase.
The subsidy will increase output to Q2 and reduce the price to P2. The amount per unit of the subsidy is given by the vertical distance between the two supply curves and the total cost of the subsidy is given by the shaded area
Reasons for giving Subsidies
A subsidy may be given:
▪ To assist the poor
▪ to help producer
▪ To encourage the consumption of goods and services with positive externalities.
Subsidies can be given to both producers and consumers. Where the subsidy is given to consumers it will be the demand curve that shifts to the right.