Lesson preview · Taxes and subsidies on goods
Taxes and subsidies: who really pays, and who really gains?
~8 min · Free to read
Imagine a country puts a tax of 10 dollars on every school uniform, and the law says shops must pay it. Before the tax, a uniform cost 30 dollars. After it, a uniform costs 38.
Each shop sends 10 dollars per uniform to the government and keeps 28, just 2 less than before. So parents pay 8 dollars of the tax and shops 2, though the law named the shops.
Key Term
A per-unit tax moves supply up
A per-unit tax is a fixed amount charged on each item sold. To sellers it is like an extra cost: whatever number they sell, they now need 10 dollars more for each uniform. So supply moves up by exactly the tax. Label it S + tax.
Buyers pay the price where S + tax meets demand. Sellers keep that price minus the tax.
Key Term
Who really pays: tax incidence
Legal incidence is who must send the money to the government. Economic incidence, often just called tax incidence, is how the burden is really split: buyers pay a higher price, and sellers keep less per sale.
The side that responds less to price pays more. Most parents have to buy uniforms, so their demand is inelastic: it falls only a little when the price rises. Shops can easily fill their shelves with other clothes, so supply is elastic: shops respond strongly to the price they keep.
Trap · Common Misconception
"The tax falls on whoever the law names"
The law only decides who sends the money. If the law made parents send the 10 dollars to the government themselves, shops would have to cut their price to 28 to keep selling. Parents would pay 28 + 10 = 38. Same prices, same split.
Uniform sales fell from 20,000 a month to 18,000, so the tax raises 10 × 18,000 = 180,000 dollars a month, not 10 × 20,000.
Same tax, same supply, three different splits: the side that finds it harder to walk away from the market pays more of the tax.
Why tax tobacco and fuel? Demand for both is inelastic: a tax cuts sales by a smaller percentage than it raises the price. So the tax keeps raising money. Governments also want less of both: smoking harms health, and burning fuel pollutes the air others breathe. The World Health Organization calls tobacco taxes the most cost-effective way to reduce tobacco use. Evidence: robust that tobacco tax rises cut tobacco use and bring in more money.
Who ends up paying? In 2009 the United States raised its national cigarette tax by about 62 cents a pack, from 1 April. In March, ahead of the tax, the market leader, Philip Morris, raised prices on its main brands, including Marlboro, by 71 cents a pack. So buyers of those brands paid more than the whole tax. But in 12 European countries in the early 1990s, cigarette prices rose by less than the tax, most of all where more firms competed. Evidence: mixed on whether smokers pay more than the whole tax.
Firms with few rivals can raise prices by more than a tax. In the simple supply-and-demand model, where many firms compete, buyers pay at most the whole tax.
Fuel is similar. In the first year or so, drivers can’t cut back much, while fuel sellers can easily sell elsewhere. So drivers probably pay most of a fuel tax.
Check yourself · no marks
A government adds a tax of 1 dollar to every cinema ticket. The ticket price rises from 12.00 to 12.20 dollars, and weekly sales fall from 50,000 to 48,000. Who bears more of the tax, and how much does the tax raise each week?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Key Term
A subsidy is a tax in reverse
A per-unit subsidy is a payment from the government to sellers for each item sold. Say it pays 10 dollars a unit: to sellers that works like a 10-dollar cost cut, so supply moves down by exactly the subsidy. Label it S + subsidy (”+” means “with”).
The price buyers pay falls, but by less than the subsidy. Sellers get that price plus the subsidy. Both sides gain, and the less responsive side gains more.
The government’s bill is the subsidy per unit times the quantity sold once it starts.
At the starting 10-dollar subsidy, the government pays 250 dollars, but buyers and sellers gain only 225 dollars between them. A subsidy costs more than the gains it creates. The 25-dollar gap is the deadweight loss: the loss on extra units that cost more to make than buyers think they’re worth.
Tip
When a subsidy can be worth its cost
Some goods help people beyond the buyer: a vaccination protects your neighbours, and a bus ride can take a car off the road. A benefit that spills over to people outside the deal is a positive externality. Buyers leave it out when they decide, so the market makes too little. So the extra units a subsidy brings can be worth what they cost.
Practice · 1 / 6
A government puts a tax of 2 dollars on every bag of crisps, paid by the sellers. What happens to the supply curve?
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