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Taxation and Subsidy

Taxation and Subsidy

Author: Kate Eskra

Differentiate between the results of a tax and a subsidy.

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Source: Image of Tax on producers Graph created by Kate Eskra, Image of Tax on Consumption graph created by Kate Eskra, Image of Subsidy on Producers Graph created by Kate Eskra, Image of Subsidy on Consumption graph created by Kate Eskra, Image of Tax on Inelastic Demand Graph created by Kate Eskra, Image of Tax on Elastic Demand graph created by Kate Eskra

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Hi, welcome to Economics. This is Kate. This tutorial is called Taxation and Subsidy. In this tutorial, you'll be able to interpret on a graph the effect of a tax on consumers and Sellers. Then we'll look at the effect of a subsidy on both consumers and sellers. We'll talk about how elasticity affects who ends up bearing the burden of either a tax or a subsidy. And, finally, we'll talk about the differences between progressive, regressive and flat taxes.

I just want to start out here with a couple little quotes. Benjamin Franklin, said, "In this world nothing can be said to be certain except death and taxes". And Margaret Mitchell, in her book, Gone With the Wind said, "Death, taxes and childbirth! There's never any convenient time for any of them."

The point is, none of us like to pay taxes. I hate paying them, you hate paying them, we all hate paying them. But most of us recognize that if our government wants to do anything, we have to pay taxes, at least, to some extent. That's the subject of this tutorial, at least at first here.

So what is it that a tax does? Well, let's look at a graph. So here's just a regular supply and demand graph. Here's our supply one. And our demand curve which initially results in a p star and Q1, that's our equilibrium. Whenever there's a tax, that is going to shift supply up and to the left.

Remember, the tax is what a producer's going to have to pay back to the government because here making it a per unit tax on sellers. So that increases their cost of production, which shifts supply to the left. What that's going to do is increase the price that consumers are going to pay. That's what I'm noting here, Pc.

At the same time that's going to decrease the price that producers receive. Pp. So the amount of the taxes, the vertical distance between the supply curves. If we look at that, even though this is what consumers are paying, that's not what producers are receiving because they have to pay the amount of the tax to the government. So at the end of it, this is what they receive. Notice also that the equilibrium quantity has decreased from Q1 to Q2.

If in fact we were looking at instead of a per unit tax on sellers a per unit tax on consumption, it's going to have the exact same ultimate outcome where consumers are paying higher prices, and producers are receiving lower prices. It's just that the new market price-- here it was the price that consumers are paying. There would be the price that sellers are receiving. So that would just be flip flopped but it's the same outcome.

A subsidy is different. A subsidy is support offered by the government to a business or individual to incentivize production of that good or service. So a subsidy is meant to give an incentive to produce more or to produce something in general.

Here, we have the same looking graph supply and demand. But this time because this is going to decrease the cost of production or offer an incentive to produce more, supply shifts to the right and the amount, the vertical distance is the amount of the subsidy.

Here was our p star, our initial equilibrium price and quantity. Now that supply has increased, the price that consumers pay this time falls to Pc. And the price that producers are receiving because they get this-- this is what consumers are paying but they get the amount of the subsidy. So they actually get this price up here.

Again, if instead we were looking at a per unit subsidy on consumption versus production it would have this same impact in the end. Consumers are going to pay lower prices with subsidies, producers will receive higher prices with subsidies. But the new market price would just be flip flopped. Instead of what consumers are paying it would be what sellers are receiving.

Now the question is, who bears the burden? Who's impacted more? If we have a tax, who's going to pay more of it, the consumer, the producer or both? Usually, it's going to be a combination of them. But it really depends on the good or service. And it's the elasticity that will show us who bears the burden of more.

Here I have a very inelastic demand curve. So here the demand is certainly more inelastic then the supply. Remember with inelastic demand, for whatever reason, consumers do not respond much to a price change, they continue to purchase the good or service as prices rise.

So knowing that, with the tax supply shifts up and to the left. Look at what producers can do. The price raise goes up quite a bit. It rises from P1 up to P2. Producers know that they can raise price and cover most of the tax without losing much at all in terms of sales. So they don't lose much in sales, variable to raise price up, and the difference between what they're receiving and what price used to be is not very much at all. They are able to have the consumer absorb most of that tax increase.

Here though, when we have more elastic demand than supply they can't raise price much. With elastic demand, consumers do change their buying habits as price goes up or down. And so here, even though they raise prices just a little bit look at how much sales they lose.

Here the producer is going to end up bearing most of the burden because they cannot raise price much at all to offset the tax that they have to pay back to the government. So it's the elasticity of supply and demand that are going to help show us who's bearing the burden.

Let's talk about percentage taxes. Percentage taxes are tax based on a certain percentage of the price of the good. The key question that you need to ask yourself as to whether something is progressive or regressive is, who is impacted by this tax more?

With progressive taxation, a higher income earner is going to be impacted more. Because here, the tax increases as income increases. And it's not just the tax amount but the actual percentage is going to increase as income increases.

So for that reason our federal income tax structure is the perfect example of progressive taxation. I'm sure you're familiar with the tax brackets. As you make more money you might put yourself in a higher tax bracket. So for example, instead of 15% of your income going to the government that next amount of income that you earn, if it's in the next tax bracket, may be taxed at 18%, or whatever the next tax bracket is.

So as you make more money not only are you paying more but you're paying, actually, a higher percentage of that amount of money. And this is the method in our country of income redistribution. Where the wealthier bear a greater burden in terms of our income tax structure than the lower income earners.

Regressive taxation is the opposite. This is where a higher percentage is going to be paid by lower income earners compared with higher income earners. And even though they may not necessarily be intended to be regressive, sales taxes end up being regressive And people are often confused about this.

In my city where I live the sales tax is 7%. So everyone's paying the same percent. It's not as if they're targeting the poor people. But a lower income earner is definitely impacted more by that 7% sales tax. And that's because lower income individuals end up spending a much higher percentage of their income on items subject to tax.

So for this reason some states actually don't tax certain items that are considered necessities, like food or clothing. And so that's the reason. Because they don't want them to be overly regressive.

Some people suggested that there are two purposes of sales taxes. One is certainly to collect revenue for the government. But in certain goods, it can be actually to discourage consumption like with things such as cigarettes and alcohol. Make people quit, tax the heck out of them and get them to purchase less of them.

A flat tax is an amount of tax applied to all levels of income without any exemptions or deductions. So here, let's say there was a 1% tax on all of your income and you couldn't deduct or exempt any of your income from it. So as you make more money, certainly, you're going to pay a greater amount, but that percentage stays the same. It's proportional to how much you make.

So the percentage stays exactly the same regardless of income. That is what we would consider a proportional or flat tax.

In this tutorial we looked at the effects of a tax on the prices paid by consumers and producers. We also saw the effect on quantity. Depending on the elasticity, either the consumer or the producer might bear a greater burden more than the other.

We looked at different types of percentage taxes. So we looked at progressive, which impact higher income earners, regressive, which impact more so lower income earners and flat taxes which impact everybody the same, proportionally. And finally we looked at the effects of the subsidy on the prices paid by consumers and producers as well as the quantity.

Thanks so much for listening. Have a great day.

Terms to Know
Flat Tax

Amount of tax applied to all levels of income without exemptions or deductions.

Percentage Tax

Tax based on a certain percentage of the price of the good.

Progressive Taxation

Tax increases as income increases.

Regressive Taxation

A flat tax that results in a higher percentage as a proportion of income being paid by lower income earners compared with higher income earners.


Support offered by the government to a business or individual to incentivize production of a good or service.