IB Economics
Taxes and subsidies

A direct tax will refer to any charge that is both imposed and collected on a
specific group of people or organizations. An example of direct taxation would be
income taxes that are collected from the people who actually earn their income.

Indirect taxes are collected from someone or some organization other than the
person or organisation that would normally be responsible for the taxes. A sales
tax, for instance, would be considered an indirect tax because the money is
collected from retailers, not from the people who actually pay the tax (the
consumers).
There are two types of indirect taxes: SPECIFIC/FLAT RATE TAX AND AD
VALOREM TAX.
A specific or flat rate tax is when a specific amount is imposed upon a good regardless
of the price of the good e.g. 10RMB on a pack of cheap cigarettes and expensive
cigarettes. With a specific tax, if the price of cigarettes doubled, the government still only
receives 10RMB per packet.
An ad valorem tax is expressed as a percentage, e.g. 15% of the selling price. Ad
valorem taxes are the most commonly applied indirect taxes. As the price of a good
changes the tax going to the government changes automatically and proportionally to
the price change.
IMPOSITION OF A FLAT RATE TAX ON CIGARETTES
Over a range of prices, the demand and supply schedules record the quantity demanded
of cigarettes per month and quantity supplied per month. This is shown in the first
three columns below. Equilibrium price is_______________ and equilibrium quantity is
_____________.
Price (RMB)
Quantity demanded
(millions of packets)
50
45
40
35
30
25
1
2
3
4
5
6
Quantity supplied
(millions of
packets)
7
6
5
4
3
2
Quantity supplied after tax
(millions of packets)
6
Now if a specific tax of RMB 5 is charged on each packet sold, it means that when the
price of a packet is RMB 50, the supplier must hand over RMB 5 to the government
leaving the supplier with RMB 45. But the supplier is only willing to supply 6 million
packets if they receive RMB 45.
These figures can be fitted into an after tax supply schedule in column 4. (for you to
complete) and a new supply curve (after tax) can also be added to a supply and demand
diagram (on graph paper).
The effect of putting a tax on the good has been to shift the supply curve up by RMB 5the amount of the new tax. Note, however, the new equilibrium price has not shifted up
by the same amount as the demand curve is sloping and not vertical. In fact, the new
price has increased by ___________ to ___________ and the equilibrium quantity has
fallen to___________.
FIVE observations must be made (and shown clearly on your graph):
1. INCIDENCE: this is the division of indirect taxes between buyers and suppliers.
In the cigarettes example, who ultimately pays for the tax? Well it is equally
shared between consumers and producers. BEFORE the tax: equilibrium price
was RMB 35- buyers paid RMB 35 and sellers received RMB 35. AFTER the tax:
buyers pay RMB 37.50 (RMB 2.50 more) and sellers receive RMB 37.50 BUT have
to give RMB 5 to the government so they only receive RMB 32.50 (RMB 2.50 less)
2. GOVERNMENT REVENUE: How much does the government make out of all
this? easy this one, they will receive the amount of tax multiplied by quantity sold
= RMB 5 x __________ = RMB ___________ per month.
3. CONSUMER EXPENDITURE: How much do consumers spend before and after
tax? The formula for this is price x quantity. So before tax consumer expenditure
was___________________ and after tax it is _________________.
4. PRODUCER REVENUE: If no taxes were charged then the amount that
consumers spend (consumer expenditure) would equal the amount producer’s
receive (Producer revenue). However, with a tax imposed Producer revenue =
consumer expenditure – government revenue
5. RESOURCE ALLOCATION: The quantity demanded and produced of this good
has fallen- producers (cigarette companies) who will allocate less resources to
making cigarettes and there will be subsequent effects on tobacco farmers.
However, it might be welcomed by some people concerned with tobacco related
diseases.
AD VALOREM OR PERCENTAGE TAX
When a tax is applied as a percentage of the selling price, the supply schedule and curve
will move up proportionately at each price. This means the amount of tax collected will
be higher at higher prices. The supply curve before and after the tax imposition is
shown below. Note that the analysis is the same as with a specific or flat rate tax.
Subsidies on goods and services
Subsidies may be regarded as negative indirect taxes. Whereas the government takes
money from the sale of products with indirect taxes, it gives money when it subsidizes.
The analysis with regards to incidence, government expenditure and resource allocation
depends again on elasticity of demand and supply.
Consider the following example; the government of Zambia decides to introduce a flat
rate subsidy of Z$1 per kilo of flour. Before receiving the subsidy, producers were
willing to supply 4 million kilos at a price of 1Z$, 5 million kilos at price of 2Z$ and so
on. If, however, at a market price of 1Z$ they receive a subsidy of 1Z$ from the
government- making 2Z$ in total- they will supply 5 million kilos of flour. This
information is summarized in the schedules below.
Price Z$
Quantity demanded
(millions of kilos)
1
2
3
4
5
6
10
9
8
7
6
5
Quantity
supplied
(millions of kilos)
4
5
6
7
8
9
Quantity supplied after
subsidy
(millions of kilos)
5
6
7
8
9
10
Complete a graph showing the demand and supply curves. Before the subsidy,
equilibrium price and quantity were? After the subsidy equilibrium price and quantity
are?
1. The incidence of the subsidy is __________ to the consumer and _________to the
producer.
2. It costs the government: _____________________________
3. Resource allocation has changed: an extra __________________ of flour is produced
and consumed.