Government intervention… (when the economy needs “help”) Why do governments impose excise taxes? What is the difference between a specific and ad valorem.

Government intervention…(when the economy needs “help”)

Why do governments impose excise taxes? What is the difference between a specific and ad valorem tax?

Why do governments provide subsidies? How do you graph taxes and subsidies?

What effects do taxes and subsidies have on the producers, consumers, government, and the market?

Question

Why does the government tax alcohol more than it taxes ice cream?

Take a minute with a partner to discuss. Use your economic vocabulary.

Why do governments tax goods?Main reasons:• Governments levy (apply) taxes as a method of

gaining tax revenue – Alcohol has a far lower PED than ice cream, so Qd

will fall proportionately less for alcohol than ice cream (the gov’t revenue is greater on items with lower PED)

• Taxes can be used to dissuade (discourage) consumption of goods that are harmful to the individual (aka “sin tax”)– Alcohol causes a great deal more of negative effects

for the consumer and others – This tax’s effectiveness based highly on PED (lower

means there will be only small decreases in Qd of the taxed good)

Why do governments tax goods?

Other arguable reasons:• Taxes can be used to redistribute income

– Taxes on luxury goods reduces after-tax income, narrowing differences with incomes of lower income earners

• Taxes are a method to improve allocation of resources by correcting market imperfections (negative externalities)

Excise tax

• When we refer to “tax” above, we’re talking about an indirect tax—a tax on an expenditure– paid partly by consumers, but are paid to the government by

firms (hence, indirect)

• The question for firms then is how to pass/what percentage of the tax to pass onto consumers so that the firm is still making a profit

Indirect tax is also known as:• excise tax—imposed on particular goods and services

(again, a tax on an expenditure)– Two types: specific (unit) tax, and ad valorem

(value-added/VAT) tax

Specific (unit/flat rate) tax• Specific tax—the tax is the same amount on each unit

sold, such as amount per liter or per pound.

• The rate of tax per unit is independent of quantity or price of the good

• Most common unit taxes are on gas/petrol ($ per gallon/litre), alcohol ($ per litre), and cigarettes ($ per packet)

• Also includes import taxes, such as $ per ton of wheat/ per automobile/ per cubic meter of liquid gas

Ad valorem (value-added) tax

• Ad valorem tax—fixed percentage of the price of the good or service, based on the base value (price) of a good sold

• because the tax is calculated as a percentage of price (not fixed per unit regardless of price), the amount of tax per unit will increase as the price increases

Muy importante!

• When a tax is levied on a good/service, it is paid to the government by the firm

• For every level of output the firm is willing and able to supply to the market, it must receive a price that is higher than the retail (consumer) price by the amount of tax

• This means: there will be a leftward shift of the supply curve by the amount of tax

Graphing specific (unit) taxEffect on supply curve

• Taxes have the effect of raising costs of production, shifting the supply curve to the left. 

• For a specific tax, this will

mean that the shift will be a parallel one because the amount of tax is the same at all prices

• The vertical distance between the supply curves will give the amount of specific tax per unit 

Graphing Ad valorem (VAT) tax

Effect on supply curve

• For an ad valorem tax the curve will swing to the left, because the amount of tax per unit increases as prices get higher.

• The gap between the pre-tax supply curve and the post-tax supply curve will widen. 

Incidents

• Incidence of taxation—burden of tax shared between buyers and sellers

• The specific tax per unit is shown as the vertical distance (t) between the two supply curves. 

• The price to the consumer has risen to P2 and output of the good has fallen to Q2.

• The total government’s tax revenue is equal to the specific tax per unit multiplied by the equilibrium output after tax. (P2-tP2ac)

• The consumer’s tax burden or incidence is equal to the change in price multiplied by the equilibrium output after tax.  It is the top portion of the government’s revenue. (P1P2ab)

• The producer’s tax burden is equal to the area of the government’s tax revenue

which is not paid by the consumer.  This is the bottom portion of the government’s tax revenue. (P2-tP1bc)

Consequences of indirect taxesConsumers:• Increase in P, decrease in Qd

cause them to be worse off (less goods, higher cost)

Producers:• Reduces output (fall in P

received), leading to fall in revenues

Welfare effects:– Burden of tax on producer and

consumer – changes in producer and consumer surplus

– Tax yield minus the cost of the tax– Lower output=fewer

jobs=unemployment of workers

Distortion of the market:– Extent of the effect dependent on

the degree of elasticity – number of substitutes, addictiveness of the product, proportion of income devoted, time scale

– Underallocation of resources to production of good(s)

– Creation of underground markets – smuggling, etc.

Government:– Increases business costs –

competitiveness?– Raises revenue to help pay for

government services

Efficiency of taxation

• Inefficiency of any tax is determined by the extent to which consumers and producers change their behavior to avoid the tax

• Deadweight loss is caused by individuals/firms making inefficient consumption/production choices to avoid taxation– No change in quantity consumed=no

efficiency cost of tax

How tax incidence affects welfare

Determinants of deadweight loss

Preexisting distortions matter!

Quick review videos

• Specific vs. ad valorem taxes:

• http://youtu.be/4i_BEDS6KKc

• Calculating taxes from a graph:

• http://youtu.be/4cWoDJcgbHE