Effect of taxes and subsidies on price

Taxes and subsidies have the effect of shifting the quantity and price of goods.

Tax impact

A marginal tax on the sellers of a good will shift the supply curve to the left until the vertical distance between the two supply curves is equal to the per unit tax; when other things remain equal, this will increase the price paid by the consumers (which is equal to the new market price), and decrease the price received by the sellers. Alternatively, a marginal tax on consumption will shift the demand curve to the left; when other things remain equal, this will increase the price paid by consumers and decrease the price received by sellers by the same amount as if the tax had been imposed on the sellers, although in this case, the price received by the sellers would be the new market price. The end result is that no matter who is taxed, the price sellers receive will decrease and the price consumers pay will increase.

Subsidy impact

Marginal subsidies on production will shift the supply curve to the right until the vertical distance between the two supply curves is equal to the per unit subsidy; when other things remain equal, this will decrease price paid by the consumers (which is equal to the new market price) and increase the price received by the producers. Alternatively, a marginal subsidy on consumption will shift the demand curve to the right; when other things remain equal, this will decrease the price paid by consumers and increase the price received by producers by the same amount as if the subsidy had been imposed on the producers, although in this case, the new market price will be the price received by producers. The end result, again, is that no matter who is subsidized, the prices producers and consumers face will be the same.

Effect of elasticity

Depending on the price elasticities of demand and supply, who bears more of the tax or who receives more of the subsidy may differ. Where the supply curve is more inelastic than the demand curve, producers bear more of the tax and receive more of the subsidy than consumers as the difference between the price producers receive and the initial market price is greater than the difference borne by consumers. Where the demand curve is more inelastic than the supply curve, the consumers bear more of the tax and receive more of the subsidy as the difference between the price consumers pay and the initial market price is greater than the difference borne by producers.

An illustration

The effect of this type of tax can be illustrated on a standard supply and demand diagram. Without a tax, the equilibrium price will be at "Pe" and the equilibrium quantity will be at "Qe".

After a tax is imposed, the price consumers pay will shift to "Pc" and the price producers receive will shift to "Pp". The consumers' price will be equal to the producers' price plus the cost of the tax. Since consumers will buy less at the higher consumer price ("Pc") and producers will sell less at a lower producer price ("Pp"), the quantity sold will fall from "Qe" to "Qt".

Effect on investment

Taxes and subsidies also have effects on investments and share prices. Taxes embedded within supply costs (e.g. tax on labor costs) will reduce the amount of capital that can be purchased with $1 of investment, whereas a subsidy will have the opposite effect, allowing $1 of investment to purchase more capital. Embedded taxes in supply prices are bad for business because it means that they have to borrow more money to finance a project with a given expected amount of return, while the opposite is true when supply prices are reduced through subsidies (or through a competitive market).

See also

* excess burden of taxation
* supply and demand
* Tax incidence

References