Taxes and Subsidies

TAXES
Taxes are money collected by the government. They can be collected by federal governments (i.e. the United States of America), subnational governments (i.e. the state of Wisconsin) and local governments (i.e. the locality of Shorewood, WI). There are two main types of taxes: direct and indirect. Direct taxes are those paid directly to the government, for example income and corporate taxes. Indirect taxes are first collected by an intermediary, for example a store when one buys food or clothes, who then sends the taxes to the government. Sales taxes and sin taxes (i.e. taxes on cigarettes, alcohol and other “sinful” g/s) are indirect taxes. Governments tax for four reasons commonly known as the four Rs: revenue (taxes = money for governments to spend), redistribution (from the rich to the poor for societal equity), repricing (to make “bad” g/s more expensive), and representation (so that citizens have some sort of say over how their money is spent…the idea behind the original Tea Party).

In this example, q0 quantity of rum is demanded and supplied at $10.00. If the government places a $5.00 tax on rum to say, discourage consumption of this so-called "sin good", we see that the supply curve S0 will shift inwards to S1 because supply shifts in when it costs more to produce. The distance between the two supply curves is the value of the tax ($5.00 here). Because demand is inelastic for rum in this example, the quantity demanded only falls to q1 and consumers now pay $4.00 of the $5.00 tax. The rum producers, who have no choice but to pay the tax to the government, take a $1.00 "hit" per unit. The green rectangle shows the incidence of the tax on the consumers and the blue rectangle shows the incidence of the tax on the producers. Governments tend to tax inelastic goods because of the relatively large impact on consumers as opposed to the producers.

Above, q0 quantity of biscuits (a.k.a. cookies) is demanded and supplied at $10.00. If the government places a $5.00 tax on biscuits for whatever reason, we see that the supply curve S0 will shift inwards to S1 because, again, supply shifts in when it costs more to produce. The distance between the two supply curves is the value of the tax ($5.00). Because demand is elastic for biscuits in this example, the quantity demanded falls by a lot to q1 and consumers now pay only $1.00 of the $5.00 tax. The biscuit producers who have to pay the tax to the government take a big $4.00 "hit" per unit. Again, the green rectangle shows the incidence of the tax on the consumers (small) and the blue rectangle shows the incidence of the tax on the producers (big). Because of the adverse effects on producers, governments tend to not tax elastic goods as it doesn't achieve the four Rs of taxation very well.

SUBSIDIES
Subsidies are financial aid to firms, or money given to producers to make production cheaper. They lower the cost of production and are used to encourage production (graphically, supply shifts out). This assistance keeps prices artificially low for consumers, ensures supply from producers of "valuable goods", helps domestic firms compete internationally and, thus, are highly debated and can be evaluated from various points of view (especially via OC analysis).



Looking at the three subsidy graphs above (PED < PES, PED = PES, PED > PES), we see that the incidences from the tax graphs have flipped (now, producers on top, consumers on bottom). Moreover, as stated above, instead of the supply curves shifting in, they shift out because subsidies make production cheaper (one of our "shifters" of supply). Before the subsidy, in all three instances, the equilibrium price is $3.50 and the equilibrium quantity is q0. The value of the subsidy is $1.00, which is also the distance between S0 and S1. If PED equals PES, the incidence of the subsidy is shared equally between consumers and producers. The market price of the product falls by exactly half the value of subsidy (in this case, $0.50). Thus, producers are encouraged to produce and consumers are encouraged to consume (milk in this example).
Evaluative questions: aren't subsidies funded by taxes? Yes! Thus, an evaluative discussion around OCs and taxation in general could occur.
When PED < PES (or demand is inelastic), quantity demanded falls very little and consumers receive the bulk of the incidence of the subsidy. In this case, the price falls by more than half the value of the subsidy ($0.90). Conversely, when demand is relatively elastic, quantity demanded does not fall by much and producers receive the bulk of the subsidy. The market price falls by less than half the value of the subsidy ($0.10). For all cases of subsidies, market price falls, producers receive more income and consumers buy more. However, money is spent by government so subsidies can be polarizing.