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Taxes and Subsidies

Taxes and Subsidies

Author: Kate Eskra

This lesson covers taxes and subsidies.

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Source: Image of Tax Graph created by Kate Eskra, Image of Consumer and Producer Surplus Before/After Tax created by Kate Eskra, Image of Consumer and Producer share of Tax Incidence created by Kate Eskra, Images of Tax Incidence with Elastic/Inelastic Supply and Demand created by Kate Eskra, Image of Subsidy graph created by Kate Eskra, Image of Subsidy incidence on Elastic/Inelastic Demand created by Kate Eskra

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Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on Taxes and Subsidies. As always, my key terms are in red, and my examples are in green. So in this tutorial, you'll interpret the effect of a tax on both consumers and sellers. We'll interpret the effect of a subsidy on both consumers and sellers as well. We'll talk about how it's elasticity that affects who bears the burden of a tax or a subsidy.

So we know that we pay taxes on a lot of things. And none of us like paying taxes. But we have to do it. So we pay taxes on our income at the local, state, and federal levels. We pay taxes on a lot of goods we purchase. And we pay taxes on services we purchase as well.

What we do in economics is try to consider how this changes the overall market outcome. So how will the quantity purchased or supplied be affected? And then how is the price of the good affected as well?

So an excise tax is what we'll be looking at really here. And that's a tax paid by the supplier or producer of a good. And it can be imposed by any government strata-- so federal, state, or local level.

So here's a graph for a per unit tax on sellers. And sometimes this gets confusing, so let's walk our way through it for a minute. What happens when there's a tax is basically the supply curve is shifting to the left. This is the amount of the tax right here, the amount that the supply is shifting to the left. And what that's going to do is increase the price that consumers are going to pay, and I indicate that by Pc. So if this was the initial equilibrium price, now consumers are paying this price.

But this quantity, Q2, is showing that because of the increase in price, consumers are going to buy less. The price that producers are receiving is not Pc. It's this right here, Pp. Because they have to pay that amount of the tax. So if consumers are paying this, they're only receiving that price down here.

So a lot of people would assume that if a tax is, let's say 10% in the example I'm using here that that would just increase the price of an item by 10%. That's not generally the case. If sellers were able to pass the entire amount of the tax on to us as consumers that would be shown in a graph like this. Then they would supply exactly the same quantity as before. But with most items, demand is not perfectly inelastic. Consumers do purchase less as the price rises. So usually it doesn't look like that. That's why we have this shifting to the left of the supply curve.

So what I'm going to walk you through is showing you how we can look at, if this is the amount of the tax, we can look at the change. We can look at this is the amount of the actual price increase. That's the impact on consumers. So the change in price from P* up to Pc is not the same as the amount of the tax, when demand is not perfectly inelastic, as it usually isn't. So it's less.

All right. So let's look at how this impacts the consumer and the producer. One way to do that is to look at consumer and producer surplus. So if you recall that consumer surplus is the difference between what consumers are willing to pay for things and what they have to pay. That's this blue triangle, all of the people who are receiving this item for less than they actually were willing to pay for it. Producer surplus is this green triangle here, which is all of the producers who were willing to supply something for less than they were able to receive for it.

OK. So if that's the initial consumer and producer surplus, this is the new consumer and producer surplus if the supply were to shift to this point right here with that amount of the tax. What you can see is that both consumer surplus is going to get smaller, and producer surplus is going to get smaller. What we have is tax revenue then generated. This tax revenue is the quantity being purchased times the amount of the tax. That used to be part of consumer and producer surplus, and now it's not. It's going to the government in some level.

But what we're also going to have is a dead weight loss. This is lost due to the lower quantity being purchased from the tax. So there is a dead weight loss, part of consumer and producer surplus that just is not being realized by anyone anymore.

So what we'll be able to see is whether consumers or producers are impacted more. If the consumer surplus shrinks more than the producer surplus, then we know that consumers are paying the majority of the tax. If the producer surplus shrinks more than the consumer surplus, then we know that producers are paying the majority.

This is another way to look at it, how we can see the effect on consumers and producers though. And this is kind of interesting, so it's helpful to look at it both ways. So here these are parallelograms. And the blue green ones together are that tax revenue. It's just a slightly different way of showing it. But if this is the amount of the tax, and this is the quantity being purchased that right there is the tax revenue.

The blue is really the consumer share of the consumers paying the tax. The green is the producer's share of the tax. And the red then is that dead weight loss. So either way we look at it, either way it's easier for you to understand it, it doesn't really matter. It will show the same who's paying more of the burden.

So in that parallelogram there the blue and the green are the consumer's and the producer's share, and the red is the dead weight loss, as I already said. So if the blue area then is bigger than the green area, we know in this way of looking at it, consumers would pay the majority. And vice versa would be true as well. If this green area were bigger, than we would know that producer's share would be much greater.

So how do we figure this out? Who does pay the tax burden? The tax burden is the proportion of tax born between a supplier and consumer of a good where either party may be the original tax recipient. So who ends up paying the tax-- the consumer, the producer, or both? Really, it depends on the good or service. And it all comes down to elasticity of demand or supply. And that's defined as the change in quantity demanded or supplied resulting from a change in the price of that good or service. And here we're talking about own-price elasticity.

So you can see here, for example, if we took a very elastic demand, remember elastic demand is when there are a lot of substitutes available. Consumers can just purchase a lot less of the taxed item. They'll be able to find a substitute. You can see that producers in this case cannot really raise price much at all. If this was the initial price, and this is the amount of the tax, producers can only raise price a little bit up to P2. So consumers will not be impacted as much. Producers will have to pay the majority of it, indicated by this pink arrow right here. Because they can't increase price. And there's a large decrease in the quantity purchased.

It's going to have a similar outcome when supply is inelastic. Because here producers now cannot easily find substitute uses for their inputs. And again, producers will bear most of the burden. You can see that's this big arrow here, and only increase price just a little bit. So elastic demand and inelastic supply have similar outcomes.

However, now let's look at the opposite. This is a pretty inelastic demand curve. It's not perfectly inelastic. but it is inelastic. Here consumers have a harder time finding substitutes. So when this is the case, producers can actually raise price quite a bit. So this larger arrow here represents that consumers are paying most of the burden of the tax in the form of higher prices. Whereas producers' burden, in terms of how much they're losing out on sales and how much they have to pay towards it, is not much at all.

We're going to have a similar outcome here when we have very elastic supply. You can see that the increase in price is much greater than what the producers would bear the burden. So consumers will bear the burden more for inelastic demand and very elastic supply.

Now just to close this out here, remember a subsidy is different. A subsidy is a sum that's paid, typically by a government entity, to either suppliers or consumers to assist in the production or purchase of a good or service. It's usually to encourage production of it. So when we look at subsidies, we're actually shifting the supply to the right. This is going to decrease the price that consumers pay, so consumers will pay a lower price here at Pc, but increase the price that producers are going to receive up at Pp.

So to fund the subsidy, let's keep in mind that tax revenue will have to be used from another source somewhere. So it's not really about who pays the instance. We can see here who's collecting it. So with elastic demand, producers are going to receive more of it, as you can see here. And with inelastic demand, consumers will receive more of it.

So in this tutorial we talked about the effects of a tax on the prices paid by consumers and producers. You saw the effects of a subsidy at the very end there on the prices paid by consumers and producers. And we looked at depending on, it's really the elasticity. That's what's going to help us figure out who bears the burden, whether it's more consumers or producers. Thanks so much for listening. Have a great day.

Terms to Know
Elasticity (demand, supply)

The change in quantity demanded or supplied resulting from a change in the price of a good or service—own-price elasticity.

Excise tax

Tax paid by supplier/producer of a good (can be imposed by any government strata--federal, state, local).


A sum that is paid (typically by a government entity) to either suppliers or consumers to assist in the production or purchase of a good or service.

Tax burden

The proportion of tax borne between a supplier and consumer of a good where either party may be the original tax recipient.