Taxes
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Adam Smith, 1776 – the “invisible hand of the
market”
 Markets allocate resources using the price mechanism
(shortage, surplus, equilibrium)
 Allocation is automatic due to the signal and incentive
role of price
 Related markets are concatenated (linked) through
demand and supply, and the price mechanism
 Result is social optimum (community surplus
maximized) at equilibrium price
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Adam Smith, 1776 – the “invisible hand of the market”
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Markets allocate resources using the price mechanism (shortage, surplus, equilibrium)
Allocation is automatic due to the signal and incentive role of price
Related markets are concatenated (joined) through demand and supply, and the price mechanism
Result is social optimum (community surplus maximized) at equilibrium price
 Governments intervene in markets using their
legal authority to…
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Raise funds through taxation
Regulate activity (enforce laws)
Support industries through subsidies
Provide public goods, and merit goods
Deal with “externalities”, e.g. pollution
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Consider government intervention in markets
as a question!
 Should government intervene?
▪ Maybe yes, maybe no… it all depends
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Sometimes government action helps
resource allocation, and sometimes it
doesn’t!
 You have to weigh the plusses and minuses of the
results of government action
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Taxes – indirect and direct taxes
 Government takes funds $$$
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Subsidies – industry support
 Government gives funds $$$
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Price Controls – government sets prices
 Ceilings
 Floors
 Minimum Wages
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For 99% of the world, governments get the
money they need in the form of taxes
Goods and Services are taxed (indirect tax)
Income is taxed (direct tax)
This revenue allows government to provide
services
(Governments also borrow money)
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Specific tax, per unit (domestic)
Excise tax, per unit (domestic)
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Value-added Tax, percentage (domestic)
GST, percentage (domestic)
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Customs Duty, percentage (international)
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Supply curves are parallel
because the same amount of
tax applied for each unit of
output
Excise tax, specific tax look
like this
Supply curves diverge from the
origin because the amount of
tax rises as output increases,
e.g. 10% of price
10% of $100 = $10 while
10% of $300 = $30
Sales Taxes, VAT, GST and
Customs Duties look like this
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Indirect taxes are imposed on goods and
services by the government.
The burden is shared between consumers
and producers.
Taxes are remitted by producers to the
government.
Direct taxes are on the income of the citizen
directly, e.g. income tax (more later)
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Excise Tax: Taxes imposed on particular G+S–
usually goods with inelastic demand
eg: petrol, cigarettes and alcohol
Thinking Point: Can you think of an economic
reasons why governments target these types of
goods??
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General Sales Tax (GST) or Value Added Tax
(VAT): Taxes imposed on all or (most) G+S
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Specific Tax: A tax of a specific amount to be
paid on every unit of a product sold.
Eg: $2 per pack tax on cigarettes.
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Ad Valorem Tax: A tax based on a particular
percentage of the sales price of a product. In
this case the tax increases as the price of G+S
increases.
Eg: 50% tax on sales of cigarettes ($PxQ)
S2 curve is parallel
to S1.
Amount of tax is
fixed for each unit
of output
S2 curve is
steeper than S1
because tax
increases as price
increases
If tax = 10% and P = $ 20
Tax per unit sold = $2 (0.1x 20)
If Tax = 10% and P = $ 30
Tax per unit sold = $ 3 (0.1x 30)
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Source of Government Revenue
Method to discourage consumption of goods
that are harmful to individuals/ society
Tax revenues used to redistribute income
from rich to poor
Method to improve allocation of resources
(reduce allocative inefficiency) or to correct
negative externalities
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When tax is imposed on G+S it is paid to
government by firms.
This leaves fewer resources for production,
c.p.
Thus, for every price the firm produces less
The supply curve shifts left
Let’s use diagrammatic analysis to find the
extent of the reduction in output, and the
incidence of the tax burden
Market Outcomes of
Specific Tax
Before Tax:
P* = Eqb P
Q* = Eqb
Q (intersection of S1 & D
curves)
After Tax:
S curve shift to S2 (S1+Tax)
P paid by consumers
increase to Pc and Q falls
to Qt.
Pc= P paid by consumers
Amount of tax = Pc – Pp
(tax per unit)
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Equilibrium quantity produced and consumed fall from Q*
to Qt
Equilibrium price increases from P* to Pc (P paid by
consumers)
Consumer expenditure on the good changes from P*x Q*
to Pc x Qt
Price received by firms fall from P* to Pp =( Pc – tax)
Firm revenues fall from (P* x Q*) to (Pp x Qt)
Government receives tax revenues = (Pc – Pp) x Qt amount
of tax per unit times the number of units sold (shaded
area)
There is an under allocation of resources to the production
of the good Qt less than free market Q (Q*)
Market Outcomes of
Ad Valorem Tax
Before Tax:
After Tax :
Student Task: Use same steps as
the previous diagram to
determine the market outcomes
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Outcomes are exactly the same as the
specific tax – just relate back to diagram (b)
instead.
Consumers
Society
Stakeholders
affected
Government
Producers
Consumers (households) are worse off – how??
 Pay higher prices
 Consume less quantities
 Spending is reduced also on other goods due
to paying more on the taxed good
 Increase consumption of substitute good
which may be less desirable.
Producers (firms) are worse off – how??
 Receive lower prices than before
 Sell less quantities – ie leads to lower
revenues and profits
 Firms produce less output so leads to supply
shortages in the future
Governments are the only winners from taxes
 Increase revenues – lead to budget surpluses
 Decrease spending on public goods such as
health care and environment because people
who smoke or use petrol now contribute to
the costs
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Society as whole is worse off due to higher
prices of goods and lower quantities
consumed and produced.
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Allocative inefficiencies – society not
producing what is desirable