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Taxes and Subsidies

Taxes and Subsidies

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 various economic tools. What effect do these economic tools have on their intended target, and does it improve things? Check out this explanation to learn about governmental economic tools like taxes and subsidies.

Taxes and Subsidies Definition in Economics

The government can influence markets and its citizens in many ways. Two of these types of tools are taxes and subsidies. Let's start off by establishing the difference between taxes and subsidies!

Taxes are a charge the government imposes on individuals' and firms' income and revenue. At the same time, 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 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 to give the recipients a financial incentive to pursue a certain objective.

Difference between Taxes and Subsidies

How does the differences between taxes and subsidies affect the outcome of a policy? Taxes and subsidies are two financial mechanisms the government uses; we'll cover why these exist and what implications they have for the government, citizens, and businesses.

Taxes

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 market failures is inefficient as it is not subject to competition, government-controlled markets aim to provide more socially equitable outcomes than 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 due to well-maintained and efficient roads.

Businesses benefit from government tax expenditures in various ways, whether providing support to their labor pool or infrastructure and roads for their business. While businesses are taxed heavily, it is common for them to receive some tax relief through 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 us. Check out this example below to learn more.

Consider someone who wishes to go shopping; 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. Suppose the shopper decides to walk to a nearby store. In that case, they benefit from public sidewalks and the discouragement of criminal behavior from frequent police presence.

These subtle things provide value through safety and time that many are willing to pay for.

Subsidies

Subsidies are a financial tool regulators use to address market failures. The collection of taxes pays for subsidies.

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 through tax reduction, buying surplus, loans, or cash.

The most popular uses of subsidies worldwide protect food production and agricultural 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 disrupt the free market's natural efficiency. 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 removed, the gas price for consumers would increase to make up for it. These oil subsidies keep the cost lower, which may help vulnerable citizens more than they pay for the subsidies.

However, the benefit is not universal as electric car owners, walkers, and bikers have some of their taxes on lowering drivers' gas prices. Though, the non-gas commuters benefit from lower transportation costs in the market, which effectively lowers the price of goods they 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.

Effect of Tax and Subsidy on Supply and Demand

Let's establish the difference of outcome subsidies and taxes can have on supply and demand. Government intervention can alter outcomes in a marketplace; let's analyze these effects. Analyzing how a market responds to these policies will give a better framework to understand why they may be implemented and their intentions.

Tax and Subsidy Effect on Supply

Policies like taxes and subsidies can alter supply significantly; the difference occurs whether it's used to correct competitive forces or address externalities, the market will shift accordingly. Policies can affect supply whether they're placed on producers or consumers, as changes in demand will change the equilibrium between supply and demand.

Determinants of supply and taxes and subsidies

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

  • Price of a good - Price changes has a direct supply and demand response.

  • Price of substitute goods - Changes in the price or quality of competing goods.

  • Price of inputs - Changes in the cost of production.

  • Competitive forces - The more competition in the market, the more sharply supply is affected.

  • Technology - Changes in technology affect productivity and the cost of production.

When a subsidy is applied, this is a benefit to the suppliers, receiving either a reduction in cost or cash. Either way, the subsidy is distributed, and it will increase returns for producers. Producers supply a quantity where marginal revenue (MR) equals marginal cost (MC); the subsidy raises marginal revenue, allowing producers to increase to a higher quantity. On a graph, this would appear as a rightward shift in the supply curve.

When a tax is imposed on suppliers, this increases their operating costs which will limit their production. Like above, they produce to MR=MC; however, the marginal cost is higher due to the tax. This means that firms' production quantities will not be too costly at higher quantity levels, so they will have to reduce the quantity to match the increased cost. A tax like this will shift supply to the left, resulting in lower quantity supplied and higher prices.

Tax and Subsidy Effect on Demand

It doesn't need to be said that consumption is taxed, as anyone who bought anything already knows. It may not seem like it, but demand often receives subsidies in various forms from the government, whether it's unemployment benefits or tax breaks for energy efficiency. Government interventions can affect demand even when imposed on producers, as changing the supply curve alters the equilibrium point with demand.

A subsidy can affect demand in multiple ways, usually for the better in the short run. A subsidy can make goods cheaper or more available, whether the subsidy is given to consumers or producers. A subsidy to consumers, such as the Covid-19 stimulus checks, increases disposable income, shifting the demand curve to the right. A rightward shift means an increase in quantity demanded and willingness to pay.

For as long as anyone has been alive, we've witnessed taxes affecting demand for sales, gas, or property. Any tax decreases disposable income and shifts the demand curve leftward, reducing the quantity demanded and lowering the willingness to pay higher prices.

Governments impose taxes on goods that are deemed socially negative, specifically tobacco and alcohol. This can vary between states, where progressive governments have massive cigarette taxes. This is done because the government believes that consumption should be discouraged for these products.

Tax and Subsidy Graph

By graphing the effects of taxes and subsidies, we can easily observe the differences and how it interacts with supply and demand and how these policies change the market. In the graphs below, the following abbreviations and definitions are used:

  • CS=Consumer Surplus: is the difference between a customer's willingness to pay and the actual price. In other words, a customer's excess value by buying at the equilibrium price.
  • PS=Producer Surplus: is the difference between how much it costs producers to supply a good or service, and what they receive for a price on the market. The excess value producers get for selling up to the equilibrium price.
  • DWL=Dead Weight Loss: Is the difference between the total surplus at competitive market equilibrium, and the new surplus after government intervention.

Below in figure 1 is a supply and demand graph that depicts the effects of a tax imposed on the market. A tax will reduce consumer and producer surplus in exchange for tax revenue, creating a market loss.

Taxes and Subsidies tax effect on market shown on a graph StudySmarterFig 1. Tax effect on the market

The graph above in figure 1 shows a supply and demand curve at an equilibrium price and quantity. A tax is imposed on the market; this decreases the price received by producers (P1) and increases consumer costs (P2).

Both of these changes in a price reduce the quantity supplied and demanded (Q2). Because the quantity exchanged is reduced, it lowers the total efficiency in the market; this is represented by the blue triangle (DWL). The pink rectangle represents the government's revenue from the tax.

The graph below represents how a subsidy impacts a market's supply and demand at equilibrium. A subsidy is implemented by the government, which pays producers to supply the product at a lower price.

Taxes and Subsidies subsidy effect on market shown on a graph StudySmarterFig 2. Subsidy effect on the market

Figure 2 above shows a supply and demand curve and a market at equilibrium quantity (Q1) and price (P1). A governing body implements a subsidy that pays producers to provide a lower price; this causes producers to receive a higher price (P3) and consumers to pay a lower price (P2).

Because of this, both consumers and producers receive the regular market surplus and an additional surplus created from the subsidy. Because both parties receive a better price, they exchange a higher quantity.

However, this quantity is not as efficient as the free market. Not every dollar spent on the subsidy results in an increased surplus, some of the subsidy doesn't create value (DWL).

In summary, subsidies do create a large benefit. Still, some of the benefits are lost to what can be considered disinterested customers. The big 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 who discovers a social efficiency theory.

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 taxes and subsidies, which change consumer and producer behavior, which can be seen as shifts in the supply and demand graph.
  • Taxes and subsidies majorly impact a government's budget; 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 maximizes 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 implementing taxes and subsidies.
  • 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.

Frequently Asked Questions about 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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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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What is the purpose of subsidies?

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

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What are taxes?

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

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What are subsidies?

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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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What is the difference between legal and economic tax incidence?

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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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How do taxes affect cost of production?

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Taxes increase costs of production

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

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The supply curve in the cars market would shift leftward

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

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

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In what form are subsidies usually paid out?

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Both

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

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The price that consumers pay decreases

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

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The price that producers receive increases

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What is deadweight loss?

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

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How can taxes create a deadweight loss?

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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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How can a subsidy create a deadweight loss?

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

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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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The government may want to subsidize corn producers

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Who determines the tax rate individuals pay?

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The U.S government.

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How does the government use tax to affect the economy?

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The government uses taxes to indirectly affect aggregate demand, the total demand for goods and services in the economy. Aggregate demand is crucial because a drop in aggregate demand would cause a recession in the economy. Additionally, a considerable increase would translate into a huge increase in the price level.

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What happens to a households disposable income when there is a tax decrease?

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The disposable income increases.

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What does it mean for the economy when an increase in disposable income occurs from a tax reduction?

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It means that overall consumption will increase, which will increase the total output produced and the price level.

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What does it mean for the economy when a decrease in disposable income occurs from a tax increase?

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A decrease in disposable income as a result of a tax increase would lower consumption in the economy, bringing total output produced and price level down.


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What happens when the government increases the tax businesses pay?

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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.

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What is the negative effect of a heavy tax, considering demand and supply graph?

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The negative effect is that there will be a deadweight loss. Producers will increase the prices, and at higher price consumers will demand less, creating a deadweight loss.

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How many savings are there in the economy?

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There are two types of savings in an economy, private savings, and national savings. Private savings refer to individual savings, whereas national savings refer to the government's budget and how much it is to save after consuming more of the income.

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What happens to private savings when there is an increase in taxes?

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Private savings shrinks as individuals have to use more of their income to pay taxes.

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What happens to private savings when there is a decrease in taxes?

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Private savings increases as individuals don't have to use as much of their income to pay taxes.

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Explain the relationship between taxes and the government budget.

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The tax provides the main source of government revenue, which it uses to spend on different projects in the economy. Government spending is intrinsically linked to taxes as its one of the main sources of revenue.

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What happens to national savings when government reduces taxes?

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When the government decides to reduce taxes, there is less national saving in the economy as the government's revenue decreases

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What happens to national savings when government increases taxes?

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An increase in taxes means that the government has more money to spend, which causes national savings to increase.

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What's one of the determining factors of the effect taxes have on production?

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The tax effect level caused by the tax is not contingent on whether the state receives the income from the producer or the consumer; instead, it relies on the price elasticity of both supply and demand.

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What are the effects of taxes on labor supply?

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In the near term, tax policy impacts the availability of workers. It's possible that lowering payroll taxes will encourage more people to enter the workforce or encourage those currently employed to work longer hours.

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Define subsidies

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Subsidies are benefits, usually financial, provided by the government to producers. 

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What is the consumer surplus?

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The consumer surplus represents the difference between what consumers are willing to pay and what they actually pay for the commodity. 

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What is the producer surplus?

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The producer surplus is the difference between what producers are willing to supply goods for and what they actually receive for supplying the goods. 

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Subsidies cause the producer surplus to decrease.

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False

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Subsidies cause the consumer surplus to increase.

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True

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Subsidies cause more firms to leave the market.

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False

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Firms can produce goods at lower costs as a result of subsidies.

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True

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Subsidies are provided by the government.

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True

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The government may provide subsidies when it wants to decrease the production of certain goods.

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False

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Subsidies make consumers buy more of the subsidized product.

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True

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Subsidies make producers produce more of the subsidized product.

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True

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A product on which the government provides subsidies is called a...

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Subsidized product

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A subsidy is only in the form of a cash payment.

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False

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A tax pardon is also a form of subsidy.

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True

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What do tax pardons mean?

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In the case of tax pardons, the government exempts certain producers from paying taxes.

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What is not an example of something that taxes pay for?

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Electricity

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Government-controlled markets aim to provide more socially ___________ outcomes than productively efficient ones.

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Equitable

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Which is not a way for businesses to benefit from tax expenditures.

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They help pay employee wages.

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Why do governments subsidize markets?

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The free market does not always offer low enough prices to reach poorer consumers.

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The most common subsidies seen around the world are...

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Agricultural.

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