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Taxes and Subsidies

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Economics

Have you ever wondered how the government can use its power to affect economic processes and the behavior of economic actors? While markets have mechanisms that allow them to regulate and stabilize themselves, governmental authorities may choose to intervene in the economy through the use of various types of economic tools. What effect do these economic tools have on their intended target and does it actually makes things better? Check out this explanation to learn more about governmental economic tools like taxes and subsidies.

Economic Definition of Taxes and Subsidies

The government can influence markets and its citizens in many ways. Two of these types of tools are taxes and subsidies. Taxes are a charge that the government imposes on individuals' and firms' income and revenue, while subsidies are grants or tax breaks given to individuals and firms to incentivize them to pursue a social objective that the government that issues the subsidy wishes to promote. These policies shift either the supply or demand curve depending on who and how they're implemented.

Taxes are monetary costs levied by governments on individuals and firms that are collected from their income or revenue to be transferred to the public sector.

Subsidies are direct and indirect payments provided by the government to individuals and firms with the purpose of giving the recipients a financial incentive to pursue a certain objective.

Difference between Taxes and Subsidies

Taxes and subsidies are two financial mechanisms used by the government, we'll cover why these exist and what implications they have for the government, citizens, and business.

Taxes are the mechanism by which governments collect funds from their constituents to provide public services and address market failures. Commonly taxes are the way to provide necessary structures that the market may struggle to provide universally, these things can range from public defense, police, firefighters, healthcare, mail services, and roads. While government handling of market failures is not efficient as it is not subject to competition, the goal of government-controlled markets is to provide more socially equitable outcomes than more productively efficient ones.

The majority of criticisms of taxes and government spending come from the non-universal benefits that the government provides, services vital to one aspect of a community may do nothing for another, who then see it as a waste of money. However, all citizens benefit to some degree from the government's management of things like roads, weather events, and trash services. Services provided by the government save citizens time and effort that can be quantified, such as a shorter commute as a result of well-maintained and efficient roads.

Businesses benefit from government tax expenditures in a variety of ways, whether it's providing support to their labor pool or providing infrastructure and roads for their business to take place. While businesses are taxed heavily, it is very common for them to receive some tax relief through any number of loopholes. Additionally, governments may address market fluctuations by providing subsidies that are paid for by taxation. The benefits we receive from taxation often aren't seen in the dollar value they provide for us check out this example below to learn more.

Consider someone who wishes to go shopping, in order to get to the store they must drive on roads maintained by tax dollars. If the road isn't maintained potholes may damage their car, or traffic will move slower and take way longer to get to the store. Once at the store the consumer can shop knowing that product and safety regulations guarantee that items purchased won't have adverse health effects. If the shopper decides to walk to a nearby store, they benefit from public sidewalks as well as the discouragement of criminal behavior from frequent police presence. All of these subtle things provide value, through safety and time that many are willing to pay for.

Subsidies are a financial tool regulators use to address market failures. Subsidies are paid for by the collection of taxes. Commonplace areas that receive subsidies range from healthcare, unemployment assistance, fossil fuel, agriculture, and housing. The government intervenes in these instances, as the free market does not always provide a low enough cost for enough citizens. Governments can provide subsidies in the form of tax reduction, buying surplus, loans, or even cash.

The most popular uses of subsidies by governments around the world are to protect the food production and agriculture industries. Countries guard their food supply to maintain autonomy. Governments can pay farmers for each product which will lower prices for consumers or provide low-interest loans to help farmers get through tough growing seasons. These government interventions are bad for competition and do disrupt the natural efficiency of the free market, however, they may provide a more equitable and stable market, or at least they try to. Consumers benefit from subsidies paid to businesses directly, read this example to learn more.

Recently, criticism has fallen upon subsidies paid to fossil fuel industries. However, if these subsidies were taken away, the gas price for consumers would increase to make up for it, so these oil subsidies actually keep the cost lower which may help vulnerable citizens, more than they actually pay into the subsidies. However the benefit is not universal as electric car owners, walkers and bikers have some of their taxes go to lowering drivers' gas prices. Those non-gas commuters do benefit from lower transportation costs, which effectively lowers the price of goods they do consume.

Taxes and subsidies have many uses and far-reaching implications for all aspects of our economy, part of an economist's job is to measure the effectiveness of these policies.

How Taxes and Subsidies affect Determinants of Supply

Determinants of supply are the multitude of factors that affect a firm's quantity and price supplied. Check out this overview below to see major factors that affect supply.

  • Price of a good

  • Price of substitute goods

  • Price of inputs

  • Competitive forces

  • Technology

  • Taxes & Subsidies

Taxes and their Implications on the Economy

There are numerous factors that influence a business's productive capacity and adjoining price. If you ask a libertarian which is the biggest factor, they'll say taxes. That's because taxes do have a significant effect on businesses which can generate distortions and inefficiency in the market. First and foremost, any taxation put on the producer will most likely be immediately transferred to the customer as an increase in price. Price increases as a result of taxes decrease efficiency and lower the potential multiplier effect that economies can create. Effective taxes are placed on inelastic goods supply or demand markets.

The impact of a tax largely depends on the elasticity of the market being taxed. For example, an increase in tax on city water, will not change consumers' behavior that much. Because consumers require water for drinking, cooking, and bathroom activities. This actually makes the tax quite effective, as it isn't likely to hurt demand. Alternatively, if a tax is placed on a highly elastic good such as Taco Bell, the effect on the market will be disastrous, even for the government, you can see why in the example below.

Consider the government is looking to raise money to save puppies. So it puts a flat $3 tax on all items on the taco bell menu, all purchases will raise a lot of money for the puppies. However, consumers' elasticity for taco bell is very high, meaning a change in price massively affects their demand. Due to the increase in menu costs as a result of the tax, 90% of consumers refuse to purchase. Only 10% of customers actually pay the tax, resulting in very little tax revenue and complete destruction of Taco Bell's profit margin.

Despite the tax being very high, it discouraged so many customers that the total tax revenue was very low. This is because the demand for Taco Bell is very elastic, and customers respond strongly to changes in price. If the government imposed a smaller tax that maintained the industry's consumer base, then they would receive tax income for nearly 10 times more consumers. This is an example of an ineffective tax for two reasons, it did not result in significant tax revenue, and it disrupted and risked the success of the business it was imposed on.

Taxes can create inequities in the market, as anyone who has heard Bernie Sanders give a speech knows that large firms often pay little to no taxes. Firms that are large enough can hire financial experts that can leverage their business losses to reduce the taxes owed. While this may help the business keep prices low, this tax reduction is difficult for small businesses and mom & pop shops to emulate. Resulting in corporate consolidation mergers and buyouts of huge firms.

However taxes do affect the determinants of supply in positive ways, for example, taxes can be used to pressure markets into becoming more efficient or equitable. The markets being pressured certainly don't appreciate it, but the social benefit is presumed to be greater.

Consider the increasing fuel efficiency requirements for new vehicles, the government forces producers to continually meet and improve their vehicle's gas mileage. This allows consumers to receive better quality products that save them money in the long run.

Subsidies and their Implications on the Economy

Subsidies provide the opposite effect of taxes, they are used to support critical industries, fund research, and maintain minimum standards of living. Subsidies also affect the determinants of supply, often for the better in the short run, however, they can have consequences for some. The most common subsidies are in food production, which most countries in the world use some form of. This helps a nation keep its food production industry healthy to keep the population satiated. However these subsidies in food production can hurt international trade, many have complained that Chinese farmers are out-competing others due to unfair subsidy advantages.1

The effect a subsidy has on the market depends on the elasticity of supply and demand within the target market. This can vary greatly, demand for food is usually inelastic as humans need to eat the same amount of food whether their rich or poor. In this case, subsidizing food can save consumers money, but they typically aren't buying more even with the artificially low price. Considering a highly elastic market like hot air balloon rides, consumers facing financial concerns wouldn't even consider purchasing such an expensive leisure activity. This, actually makes the effect of a subsidy greater, as a subsidy reducing consumer costs will have a larger elastic response in the demand for hot air balloon rides.

Love the Subsidies, Hate the Taxes.

Celebrity icon Elon Musk has been an outspoken critic of forms of wealth taxes or corporate tax hikes. While it's true these taxes would hurt his business and even reduce efficiency and natural market competitiveness. It's also important to note that Elon Musk's businesses have received subsidies and government benefits for decades. According to a business insider article "Musk's companies had received an estimated $4.9 billion in government support by 2015, and they've gotten more since."2 Where did that government support money come from, was it taxes?

Taxes are used to fund subsidies that provide research grants which lead to advances in technology. Firms are then able to buy this technology sooner, as researchers can leverage more risk and the technological advancement will cost less since the research was publicly funded. This can be seen in the deep dive above, as Elon Musk has used government subsidies to build profitable and effective technological advancements and products. However, governments must collect taxes to be able to give out the support money that helped build his empire.

Effect of Taxes on the Supply and Demand Graph

Below is a graphical representation of a market under heavy taxation, this limits the supply and demand for the goods. The reduction of profit discourages producers to supply more of the goods, and producers pass on some of the tax to consumers which decreases demand.

  • CS=Consumer Surplus: the excess value a customer gets by buying at the equilibrium price.
  • PS=Producer Surplus: The excess value producers get for selling up to the equilibrium price.
  • DWL=Dead Weight Loss: The lost efficiency from disruptions in the free market.

Taxes and Subsidies Tax Revenue SutdySmarterFigure 1. Tax Revenue Illustrated Model - StudySmarter

In the graph above in figure 1, we see a market previously at equilibrium that had a tax implemented on it. Without a tax, all highlighted areas would belong to either a consumer or producer surplus. We can see that the tax severely limits consumer and producer surplus. Very important to note that not all lost surplus is collected as tax, deadweight loss occurs as a result of a decrease from the equilibrium quantity. This creates an inefficiency in the market, as both suppliers and consumers would be better off at equilibrium.

To better understand this graph let's put a relatable example to what it demonstrates.

Consider the market for Cherry Pull 'n' Peel Twizzlers:

Try your best to imagine an evil government that hates happiness, and wants no one to enjoy Twizzlers, so they put a $4 tax on every package of cherry-pull 'n' peel Twizzlers.

The market at equilibrium previously had a quantity(Q1) of 1000 Twizzlers for an equilibrium price of $4 (PE)

Twizzler manufacturers decide to pay half the tax from their profit and half is to be paid by the customer.

So consumer price increases to $6(P2) and after the tax Producers receive $2(P1)

This change in price lowers the quantity(from Q1 to Q2) supplied and demanded. 1000(Q1) Twizzlers to 500(Q2)

Q1=1000 Q2=500 P2=$6 P1=$2 PE=$4

To calculate tax revenue we can use ((P2-P1)*Q2) ((6-2)500)=4*500=$2000

For the Producers' surplus, we calculate the area of the triangle (P1*Q2*0.5) 2*500*0.5=$500

Deadweight loss is the area of a triangle ((P2-P1)(Q1-Q2)0.5) (6-2)(1000-500)*0.5= 4*500*0.5=$500

In the example above, corresponding with figure 1 we can see the impact a tax has on a market. Consumer and producer surplus are severely reduced, at the cost of the tax revenue. Additionally, because the tax lowers the equilibrium quantity, there is a deadweight loss that could be occupied were the market allowed to reach equilibrium. The problem with taxation on the market isn't the lost value to the tax, but the overall loss of efficiency shown through deadweight loss.

Effect of Subsidy on Supply and Demand Graph

Below is a graphical representation of how a subsidy affects a market at equilibrium. The subsidy splits the benefit, where suppliers get a higher price, at the same time as consumers receive a lower price. How is this possible, read the example below for specific details. It's important to note that this graph represents the change in surplus as a result of the subsidy, the surplus shown is not the entire market surplus.

Deadweight Loss occurs in the market as a result of providing the goods beyond the equilibrium quantity. Of the total tax dollars required for this subsidy most of the cash creates a surplus, however, because the value of transactions after equilibrium is diminished by marginal returns, not all of the subsidy's value is realized.

Taxes and Subsidies Subsidy Effect Model StudySmarterFigure 2. Subsidy Effect Model - StudySmarter

While using the graph provided in figure 2, Consider the market of Brussel Sprouts:

Try your best to imagine an evil government that hates happiness, and wants your parents to make you eat brussel sprouts, so they put a $2 subsidy on Brussel sprouts. This means that the government tells producers to sell to consumers for $2 and the government will give $2 for each unit sold.

The market at equilibrium previously had a quantity(Q1) of 750 brussel sprouts for a price of $3(P1). With the subsidy, farmers must agree to sell at $2(P2), though the subsidy will pay farmers an additional $2 meaning they receive $4(P3) for each sale.

So consumer price is $2(P2) and Producers receive $4(P3)

This change in price increases the quantity(from Q1 to Q2) supplied and demanded.

750(Q1) brussel sprouts to 1000(Q2)

Q1=750 Q2=1000 P2=$2 P1=$3 P3=$4 Tax Burden=$2000


To calculate the increase in consumer surplus,

We find the area of the triangle right of Q1 below the demand curve

((P1-P2)*(Q2-Q1)*0.5) = (3-2)*(1000-750)*0.5 =(1)*(250)*0.5 =$125

And add it to the consumer surplus rectangle

((P1-P2)*Q1) ((3-2)*750)=$750

$750+$125=$875 increase in consumer surplus


To calculate the increase in producers' surplus,

We find the area of the triangle right of Q1 above the supply curve

((P3-P1)*(Q2-Q1)*0.5) = (4-3)*(1000-750)*0.5 =(1)*(250)*0.5 =$125

And add the producer surplus rectangle

((P3-P1)*Q1) =((4-3)*750) =$750

750+125=$875 increase in producer surplus


Deadweight loss is found by calculating the area of a triangle

((P3-P2)(Q2-Q1)0.5) (4-2)(1000-750)*0.5= 2*250*0.5=$250 DWL

In the example above, the government pays $2000 to subsidize brussel sprouts. Consumer and producer surplus both increase $875 more than their previous surplus. The total surplus created by the subsidy is $1750, which means that $250 of value is not realized and becomes a deadweight loss. This DWL is a result of customers who don't value the good enough to buy it normally. Similarly, producers can increase the quantity, but at a high cost, so it incentivizes inefficient production for higher quantity. However, it's important to weigh the $250 DWL against the $1750 gain in the total market.

Government intervention in the market through subsidies does create a benefit but it is not a 100% return on investment. Due to the nature of diminishing utility, the additional sales created by the subsidies don't generate as much value as the tax dollar injected. It's important to consider what alternatives the tax dollars used for subsidies can create. Fiscally conservative individuals would say that they should decide where to spend their money, rather than the government. This actually would eliminate the deadweight loss, as consumers can buy things that maximize their utility. When governments collect taxes it lowers consumers' ability to maximize personal utility, and the government expenditures are not as efficient as in a competitive market. Overall, government intervention in efficient markets can only hurt the market.

In summary, subsidies do create a large benefit, but some of the benefits are lost to what can be considered disinterested customers. The large benefit only creates value if the loss used to collect tax revenue is less efficient. That is what an efficiency maximization lens will consider, however, the social efficiency may be greater. Unfortunately, social efficiency is hard to quantify, maybe you'll be the economist that discovers a theory of social efficiency.

To learn more about consumer and producer surplus, check out our explanation on Equilibrium and Consumer and Producer Surplus.

Taxes and Subsidies - Key takeaways

  • Governments steer markets through the use of taxes and subsidies which changes consumer and producer behavior, which can be seen as shifts in the supply and demand graph
  • Taxes and subsidies have major impacts on the budget of a government, an increase in taxes raises their money supply, however, an increase in subsidies lowers the government's budget.
  • When a market is at equilibrium it is maximizing efficiency, implementing a tax or subsidy will disrupt and lower the overall efficiency.
  • The deadweight loss represents the lost efficiency felt by consumers and producers, this loss is created by the implementation of taxes and subsidies.
  • Who the government decides to put the tax on, is usually determined by the elasticity of the supply and demand curve, the more inelastic the better to tax.

1. Information on Chinese subsidies sourced from Reuters.com

2. Business Insider quote on Elon Musk sourced from Businessinsider.com

Taxes and Subsidies

Taxes are charges levied by governments on individuals and firms that are collected from their income or revenue to be transferred to the public sector. 

Subsidies are grants or tax breaks given to individuals and firms to incentivize them to pursue a social objective that the issuer of the subsidy wants to promote.

An example of a tax is a sales tax that consumers have to pay when purchasing an item that the sales tax is levied on.

An example of a subsidy is the government providing tax breaks for corn farmers to increase quantities of corn products supplied.

Taxes increase production costs for producers, thus shifting quantity supplied leftward along the supply curve and resulting in a higher price.

Subsidies shift quantity supplied rightward along the supply curve, increasing the price the producers receive for their product or service.

Both taxes and subsidies tend to create deadweight losses due to the new quantities that they set for the market being either too low or too high to optimize efficient allocation of resources.

Tax expenditures are technically a type of subsidy provided as a tax break. They are given as deductions, exclusions, and other tax benefits. 

While tax expenditures may be a type of subsidy, not all subsidies are tax expenditures; thus, the two are related but not completely equivalent.

Final Taxes and Subsidies Quiz

Question

Why does the government need to enforce taxes?

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Answer

Taxes are generally the main source of revenue for governments. Furthermore, taxes can be used to manipulate markets if the government finds it necessary.

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Question

What is the purpose of subsidies?

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Answer

Subsidies are generally used by governments to create economic incentives to generate higher quantities supplied of subsidized goods and services.

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Question

What are taxes?

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Answer

Taxes are contributions levied by governments on individuals and firms that are collected from their income or revenue.

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Question

What are subsidies?

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Answer

Subsidies are benefits provided by the government to individuals and firms, usually with the intent to create a financial incentive for the recipients. 

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Question

What is the difference between legal and economic tax incidence?

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Answer

Legal tax incidence is who the taxes are technically levied on by the authorities, while economic tax incidence is about who actually bears the brunt of the tax.

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Question

How do taxes affect cost of production?

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Answer

Taxes increase costs of production

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Question

Suppose the government suddenly raised taxes on steel. How would this increase affect the supply curve for cars?

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Answer

The supply curve in the cars market would shift leftward

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Question

How does an increase in taxes on inputs affect the market price?

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Answer

The market price increases due to an increase in production costs.

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Question

In what form are subsidies usually paid out?

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Answer

Both

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Question

How does a subsidy affect the price that consumers pay for the subsidized good/service?

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Answer

The price that consumers pay decreases

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Question

How does a subsidy affect the price that producers receive for the subsidized good/service?

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Answer

The price that producers receive increases

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Question

What is deadweight loss?

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Answer

Deadweight loss is a social cost created by market inefficiencies, which is when supply and demand are out of equilibrium.

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Question

How can taxes create a deadweight loss?

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Answer

Since taxes are likely to cause the market price to increase, consequently there will be a number of consumers that will be unable or unwilling to purchase the taxed good at the higher price.

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Question

How can a subsidy create a deadweight loss?

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Answer

Since subsidies will likely increase quantity supplied, total surplus in the market will decrease and thus lead to deadweight loss.

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Question

Suppose the government would like prices of corn to decrease. Which should they use to create the desired effect in the corn market?

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Answer

The government may want to subsidize corn producers

Show question

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