The effect of indirect taxes, subsidies and price controls Government policies to improve market outcomes

What are indirect taxes?

Indirect taxes are taxes placed on consumption, production or the use of goods and services.

They are described as indirect taxes because while the tax is paid to the government by producers it is effectively passed on to and paid by consumers.

There are two types of indirect tax:

  • Specific tax: The tax is a set sum of money per unit. For example excise duty on fuel production is levied in Australia at about 40c per litre (Feb 2017).
  • Ad valorem tax: The tax is a percentage of the value of the transaction. For example Goods and Services Tax (GST) is levied at 10% of the value added at each production stage of a product.

Why would a government IMPOSE an indirect tax?

  • Increase the price in order to reduce the quantity consumed because it is a demerit good or leads to negative externalities
  • Reduce or eliminate deadweight loss
  • Collect tax revenue to pay for the costs caused by the products or for general use

Impact on market depends on:

  • Size of the tax
  • The response of consumers to the price rise (known as the price elasticity of demand)
  • The response of producers to the price rise (known as the price elasticity of supply)

Impact on efficiency

  • If the tax equals the negative production externality market failure is corrected.
  • If it is greater than the externality (or there was no externality) the tax creates its own deadweight loss.
  • If there is no market failure, there are better ways to raise tax revenue.

ACTIVITY 1: SIN TAXES

A sin tax is an indirect tax levied on certain goods considered to be harmful by society, for example, alcohol, tobacco, lollies, sugary soft drinks, fast foods and gambling.

Sin taxes:

  • raise the price of these products to reduce demand
  • raise tax revenue which can be used to pay for the damage to society caused by these goods

The balance achieved between these two outcomes will depend on how sensitive consumers are to price increases (i.e. the price elasticity of demand)

Describe four problems in using sin taxes to solve the problems caused by demerit goods and services.

What is a subsidy?

A subsidy is a payment by the government to a producer to cut prices or increase output.

Why might a government subsidise a producer?

  • Increase the availability of products that cause positive externalities e.g. health care and renewable energy
  • Allow the producer to export more by making them more internationally competitive
  • Project employment or, in the case of infant industries, secure long term expansion
  • Give into a rent seeking, special interest group

Impact on market depends on:

  • Size of the subsidy
  • The response of consumers to the price cut (known as the price elasticity of demand)
  • The response of producers to the reduction in costs (known as the price elasticity of supply)

Impact on efficiency

  • If the subsidy equals the positive production externality market failure is corrected.
  • If it is greater than the externality (or these was no externality) the subsidy creates its own deadweight loss.
  • The cost of the subsidy will be met indirectly by taxpayers.

Price ceiling or maximum price

Why might a government impose a price ceiling?

  • For equity reasons
  • Product is a basic need and considered to be an entitlement
  • Suppliers can abuse their monopoly power
  • Supply is, in the short term, restricted (e.g. wartime)

Possible examples

  • Water charges
  • Fuel costs
  • Staple foods
  • Housing costs
  • Tickets for big events

Price floor or minimum price

Market equilibrium price is considered to be too low. On what grounds might this opinion be based?

  • Income of producers not high enough.
  • Incomes unstable.

ACTIVITY 3: MINIMUM WAGES

Describe the impact of setting minimum wages in a sector of the labour market on:

(a) Labour force participation

(b) Unemployment

(c) Income fairness

END OF PRESENTATION

Created By
Andrew Tibbitt
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