Standard Sales Tax Deduction the Irs Allows for Your State, Family Size, and Income
Topic 4 Function ii: Applications of Supply and Demand
4.seven Taxes and Subsidies
Learning Objectives
By the end of this department, you will be able to:
- Distinguish between legal and economic tax incidence
- Know how to correspond taxes by shifting the curve and the wedge method
- Understand the quantity and price bear upon from a tax
- Describe why both taxes and subsidies cause deadweight loss
Taxes are non the nigh pop policy, but they are often necessary. We will look at two methods to empathise how taxes affect the marketplace: past shifting the curve and using the wedge method. Offset, we must examine the difference betwixt legal tax incidence and economic taxation incidence.
Legal versus Economic Taxation Incidence
When the government sets a tax, it must make up one's mind whether to levy the tax on the producers or the consumers. This is calledlegal tax incidence. The most well-known taxes are ones levied on the consumer, such as Government Sales Tax (GST) and Provincial Sales Revenue enhancement (PST). The government also sets taxes on producers, such as the gas tax, which cuts into their profits. The legal incidence of the taxation is really irrelevant when determining who is impacted by the taxation. When the regime levies a gas tax, the producers will pass some of these costs on as an increased price. Likewise, a tax on consumers will ultimately decrease quantity demanded and reduce producer surplus. This is because the economical revenue enhancement incidence, or who actually pays in the new equilibrium for the incidence of the tax, is based on how the market responds to the price change – not on legal incidence.
Tax – Shifting the Curve
In Topic 3, nosotros adamant that the supply curve was derived from a firm'southward Marginal Toll and that shifts in the supply bend were acquired by any changes in the market that caused an increment in MC at every quantity level. This is no unlike for a tax. From the producer's perspective, any revenue enhancement levied on them is just an increase in the marginal costs per unit of measurement. To illustrate the effect of a tax, permit's expect at the oil marketplace again.
If the government levies a $iii gas tax on producers (a legal revenue enhancement incidence on producers), the supply curve volition shift upward by $3. As shown in Figure 4.8a beneath, a new equilibrium is created at P=$5 and Q=ii million barrels. Note that producers practise non receive $v, they now merely receive $2, as $3 has to be sent to the government. From the consumer's perspective, this $1 increase in price is no different than a price increase for any other reason, and responds by decreasing the quantity demanded for the higher priced good.
What if the legal incidence of the tax is levied on the consumers? Since the demand curve represents the consumers' willingness to pay, the demand curve volition shift downwardly every bit a result of the tax. If consumers are just willing to pay $4/gallon for four million gallons of oil merely know they will face a $three/gallon revenue enhancement at the till, they will only purchase 4 one thousand thousand gallons if the ticket price is $1. This creates a new equilibrium where consumers pay a $ii ticket price, knowing they will have to pay a $three revenue enhancement for a total of $five. The producers volition receive the $2 paid earlier taxes.
Note that whether the revenue enhancement is levied on the consumer or producer, the final upshot is the aforementioned, proving the legal incidence of the tax is irrelevant.
Tax – The Wedge Method
Some other method to view taxes is through the wedge method. This method recognizes that who pays the tax is ultimately irrelevant. Instead, the wedge method illustrates that a tax drives a wedge between the cost consumers pay and the revenue producers receive, equal to the size of the tax levied.
Equally illustrated below, to discover the new equilibrium, one but needs to find a $3 wedge betwixt the curves. The first wedge tested is only $0.seven, followed by $1.5, until the $3.0 tax is found.
Market Surplus
Like with price and quantity controls, i must compare the market surplus before and after a cost change to fully sympathise the effects of a tax policy on surplus.
Before
The market surplus earlier the tax has not been shown, as the process should exist routine. Ensure yous understand how to get the following values:
Consumer Surplus= $4 million
Producer Surplus = $8 1000000
Market Surplus = $12 one thousand thousand
Afterward
The market surplus after the policy can be calculated in reference to Figure 4.7d
Consumer Surplus (Blue Area) = $1 million
Producer Surplus (Red Surface area)= $2 one thousand thousand
Government Revenue (Dark-green Area) = $vi 1000000
Market Surplus= $9 million
Why is Regime Included in Marketplace Surplus
In our previous examples dealing with market surplus, we did not include any discussion of government revenue, since the government was not engaging in our market. Call up that market surplus is our metric for efficiency. If regime was non included in this metric, it would not be very useful. In this case a million-dollar loss to government would exist considered efficient if it resulted in a $i gain to a consumer. To ensure that our metric for efficiency is nevertheless useful nosotros must consider government when computing market surplus.
As with the quota – both consumer and producer surplus decreased because of a reduced quantity. The deviation is, since the cost is changing, there is redistribution. This time, the redistribution is from consumers and producers to the authorities. Remember, only a change in quantity causes a deadweight loss. Price changes simply shift surplus around between consumers, producers, and the government.
Transfer and Deadweight Loss
Permit's look closely at the tax's impact on quantity and cost to run across how these components affect the market.
Transfer – The Impact of Price
Due to the revenue enhancement's effect on price, areas A and C are transferred from consumer and producer surplus to government revenue.
Consumers to Government – Area A
Consumers originally paid $4/gallon for gas. Now, they are paying $5/gallon. The $1 increase in price is the portion of the tax that consumers have to behave. Despite the fact that the tax is levied on producers, the consumers take to bear a share of the price change. The size of this share depends on relative elasticity – a concept we will explore in the next section. This is because a subtract in toll to producers means quantity supplied is falling, and in order to maintain equilibrium, quantity demanded must fall by an equal corporeality. This toll change means the government collects $1 x 2 meg gallons or $two million in tax revenue from the consumers. This is a straight transfer from consumers to government and has no issue on market place surplus.
Producers to Government – Area C
Originally, producers received acquirement of $4/gallon for gas. Now, they receive $2/gallon. This $2 decrease is the portion of the tax that producers have to deport. This means that the government collects $2 x 2 million gallons or $4 million in tax revenue from the producers. This is a transfer from producers to the government.
As calculated, the authorities receives a total of $6 million in tax acquirement, which is taken from consumers and producers. This has no bear on on net market surplus.
Deadweight Loss – The Affect of Quantity
If nosotros merely considered a transfer of surplus, in that location would be no deadweight loss. In this case, though, nosotros know that cost changes come with a alter in quantity. A higher price for consumers will cause a decrease in the quantity demanded, and a lower price for producers volition crusade a decrease in quantity supplied. This reduction from equilibrium quantity is what causes a deadweight loss in the market since there are consumers and producers who are no longer able to buy and supply the good.
Consumer Surplus Decrease – Area B
Due to the increase in cost, many consumers will switch away from oil to alternative options. This subtract in quantity demand of 1.5 one thousand thousand gallons of oil causes a deadweight loss of $1 one thousand thousand.
Producer Surplus Subtract – Area D
Producers, who now receive just $ii.00/gallon for their production, will also decrease quantity supplied by 1.five meg gallons of oil. It is no coincidence that the size of the subtract is the same. When y'all create the wedge between consumers and producers, you are finding the quantity where the full corporeality of the tax is incurred only the market is all the same at equilibrium. Think that quantity demanded must equal quantity supplied or the market place will non exist stable. This mirrored decrease in quantity ensures this is still the instance. Observe, however, that the impact of this quantity drop causes a larger decrease in producer surplus than consumer surplus totalling $2 million. Over again, this is due to elasticity, or the relative responsiveness to the price chance, which will exist explored in more item shortly.
Together, these decreases cause a $3 one thousand thousand deadweight loss (the departure between the marketplace surplus earlier and market surplus after).
Subsidy
While a taxation drives a wedge that increases the cost consumers have to pay and decreases the price producers receive, a subsidy does the reverse. Asubsidy is a do good given past the authorities to groups or individuals, usually in the form of a cash payment or a tax reduction. A subsidy is often given to remove some type of burden, and it is often considered to exist in the overall interest of the public. In economic terms, a subsidy drives a wedge, decreasing the price consumers pay and increasing the toll producers receive, with the government incurring an expense.
In Topic 3, we looked at a example study of Victoria'southward competitive housing marketplace where high need drove up prices. In response, the government has enacted many policies to allow low-income families to still go homeowners. Let'due south await at the effects of one possible policy. (Annotation the following policy is unrealistic but allows for piece of cake comprehension of the issue of subsidies).
In the market to a higher place, our efficient equilibrium begins at a toll of $400,000 per dwelling, with 40,000 homes being purchased. The government wants to substantially increment the number of consumers able to purchase homes, so it issues a $300,000 subsidy for any consumers purchasing a new dwelling. This drives a wedge betwixt what home buyers pay ($250,000) and what home builders receive ($550,000).
With all government policies we have examined so far, we accept wanted to determine whether the consequence of the policy increases or decreases market place surplus. With a subsidy, we want to do the same analysis. Unfortunately, because increases in surplus overlap on our diagram, it becomes more complicated. To simplify the analysis, the following diagram separates the changes to producers, consumers, and government onto different graphs.
Producers
The producers at present receive $550,000 instead of $400,000, increasing quantity supplied to threescore,000 homes. This increases producer surplus byareas A and B.
Consumers
The consumers now pay $250,000 instead of $400,000, increasing quantity demanded to lx,000 homes. This increases consumer surplus byareas C and D.
Government
The government now has to pay $300,000 per home to subsidize the 60,000 consumers buying new homes (this policy would cost the government $xviii billion!!) Graphically, this is equal to a decrease in government to areas A, B, C, D and E.
Result
Our total gains from the policy (to producers and consumers) are areasA, B, C and D,whereas full losses (the cost to the government) are areasA, B, C, D, and E.To summarize:
AreasA, B, C and D are transferred from the regime to consumers and producers.
Expanse Eastward is a deadweight loss from the policy.
There are ii things to notice well-nigh this case. First, the policy was successful at increasing quantity from 40,000 homes to 60,000 homes. Second, it resulted in a deadweight loss because equilibrium quantity was too high. Remember,anytime quantity is changed from the equilibrium quantity, in the absence of externalities, there is a deadweight loss. This is truthful for when quantity is decreased and when it is increased.
http://www.investopedia.com/terms/southward/subsidy.asp
Summary
Taxes and subsidies are more than complicated than a price or quantity control as they involve a 3rd economic role player: the government. Every bit nosotros saw, who the tax or subsidy is levied on is irrelevant when looking at how the market ends up. Note that the final three sections accept painted a fairly grim picture about policy instruments. This is because our model currently does not include the external costs economic players impose to the macro-surroundings (pollution, disease, etc.) or attribute any significant to equity. These concepts will be explored in more detail in subsequently topics.
In our examples above, nosotros see that the legal incidence of the tax does non thing, but what does? To determine which party bears more of the burden, we must apply the concept of relative elasticity to our analysis.
Glossary
- Economical Tax Incidence
- the distribution of taxation based on who bears the burden in the new equilibrium, based on elasticity
- Legal Tax Incidence
- the legal distribution of who pays the tax
- Subsidy
- a benefit given by the regime to groups or individuals, unremarkably in the form of a cash payment or a tax reduction It is oft to remove some type of burden, and information technology is ofttimes considered to be in the overall interest of the public
Exercises 4.7
Refer to the supply and demand curves illustrated beneath for the post-obit Iii questions. Consider the introduction of a $20 per unit of measurement revenue enhancement in this market.
i. Which areas represent the loss to consumer AND producer surplus equally a result of this revenue enhancement?
a) k + f.
b) j + g.
c) thou + j.
d) k + f + j + k.
2.Which areas represent the gain in government revenue as a result of this tax?
a) k + f.
b) j + g.
c) k + j.
d) k + f + j + g.
iii. Which areas represent the deadweight loss associated with this tax?
a) f + one thousand.
b) grand – one thousand.
c) j – f.
d) k + f + j + one thousand.
iv. Assume that the marginal cost of producing socks is constant for all sock producers, and is equal to $5 per pair. If government introduces a constant per-unit tax on socks, so which of the following statements is False, given the after-tax equilibrium in the sock market? (Assume a downward-sloping demand curve for socks.)
a) Consumers are worse off as a result of the tax.
b) Spending on socks may either increase or decrease as a result of the tax.
c) Producers are worse off equally a result of the tax.
d) This tax will effect in a deadweight loss.
v. Refer to the supply and demand diagram beneath.
If an subsidy of $iii per unit is introduced in this market, the price that consumers pay will equal ____ and the price that producers receive net of the subsidy will equal _____.
a) $2; $5.
b) $3; $half dozen.
c) $4; $7.
d) $5; $8.
6. If a subsidy is introduced in a market, and so which of the following statement is True? Assume no externalities
a) Consumer and producer surplus increment simply social surplus decreases.
b) Consumer and producer surplus decrease simply social surplus increases.
c) Consumer surplus, producer surplus, and social surplus all increase.
d) Consumer surplus, producer surplus, and social surplus all decrease
Use the diagram below to answer the following TWO questions.
7. If a $half dozen per unit taxation is introduced in this market, and so the toll that consumers pay will equal ____ and the price that producers receive internet of the tax will equal _____.
a) $10; $4.
b) $9; $iii.
c) $eight; $2.
d) $vii; $1.
viii. If a $6 per unit tax is introduced in this marketplace, then the new equilibrium quantity will exist:
a) 20 units.
b) 40 units.
c) 60 units.
d) None of the above.
nine. Which of the post-obit statements about the deadweight loss of taxation is True? (Presume no externalities.)
a) If there is a deadweight loss, and so the revenue raised past the revenue enhancement is greater than the losses to consumer and producers.
b) If there is no deadweight loss, then acquirement raised by the government is exactly equal to the losses to consumers and producers.
c) Both a) and b).
d) Neither a) nor b).
10. Which of the post-obit correctly describes the equilibrium furnishings of a per-unit tax, in a market with NO externalities?
a) Consumer and producer surplus increase simply social surplus decreases.
b) Consumer and producer surplus decrease but social surplus increases.
c) Consumer surplus, producer surplus, and social surplus all increase.
d) Consumer surplus, producer surplus, and social surplus all decrease.
11. Which of the following correctly describes the equilibrium effects of a per unit subsidy?
a) Consumer price rises, producer price falls, and quantity increases.
b) Consumer price falls, producer price falls, and quantity increases.
c) Consumer price rises, producer price rises, and quantity increases.
d) Consumer cost falls, producer cost rises, and quantity increases.
12. Refer to the supply and need diagram beneath.
If an output (excise) tax of $five per unit is introduced in this marketplace, the toll that consumers pay will equal ____ and the price that producers receive internet of the tax volition equal _____.
a) $5; $x.
b) $6; $11.
c) $7; $12.
d) $8; $3.
13. Consider the supply and demand diagram beneath.
If a $2 per unit subsidy is introduced, what will be the equilibrium quantity?
a) 40 units.
b) 45 units.
c) fifty units.
d) 55 units.
Consider the supply and demand diagram below. Assume that: (i) in that location are no externalities; and (ii) in the absence of authorities regulation the market supply curve is the one labeled S1.
14. If a $five per unit tax is introduced in this market, which area represents the deadweight loss?
a) a.
b) a + b.
c) b + c.
d) a + b + c.
Source: https://pressbooks.bccampus.ca/uvicecon103/chapter/4-6-taxes/
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