Taxes and Subsidies: Impact on Equilibrium

Taxes and Subsidies: Impact on Equilibrium Taxes and subsidies are instruments of government intervention that, unlike price controls, work through the market mechanism. They shift supply or demand curves, creating a new equilibrium. Understanding their impact is important for policy analysis and investments.

Tax on a Good Excise tax — a tax per unit of a good. It can be levied on sellers or on buyers.

Tax on the seller: The supply curve shifts upward by the amount of the tax For each quantity, sellers want a price higher by the sum of the tax Or: at each price, they are ready to sell less

Tax on the buyer: The demand curve shifts downward by the amount of the tax For each quantity, buyers are willing to pay less by the sum of the tax

Key insight: the result is the same regardless of who is formally taxed! The tax burden is distributed between buyers and sellers by economic laws, not by legal form.

Tax Incidence Who really pays the tax? The answer depends on elasticity:

Rule: The side with less elastic demand/supply bears the greater part of the burden. Less elastic = less able to avoid the tax.

If demand is inelastic (buyers cannot refuse — medications, cigarettes): Sellers can shift the tax onto buyers The price for buyers rises almost by the entire amount of the tax Buyers bear the main burden

If supply is inelastic (sellers cannot exit — land, specific assets): Sellers cannot shift the tax The price for buyers changes little Sellers bear the main burden

Formula: buyer's share = Es / (Es + |Ed|), where Es is supply elasticity, Ed is demand elasticity.

Deadweight Loss from Taxes Tax creates a “wedge” between the price for the buyer and the price for the seller. This distorts incentives:

Buyers pay more → buy less Sellers get less → produce less The quantity falls below the efficient level Some mutually beneficial deals do not occur

Deadweight loss (DWL) — welfare loss that nobody receives: neither buyers, nor sellers, nor the government. This is “dead weight” of the tax.

Graphically: DWL is the triangle between the demand and supply curves, from the new quantity to the old.

Formula for DWL: ≈ ½ × tax × change in quantity.

The more elastic demand and supply are, the higher the DWL.

Subsidies Subsidy — a negative tax. The government pays sellers or buyers for each unit of the good.

Subsidy to sellers: The supply curve shifts down by the amount of the subsidy Price for buyers decreases Quantity increases

Subsidy to buyers: The demand curve shifts up by the amount of the subsidy Similar result

Distribution of benefits: just like tax burdens, the benefits from subsidies are distributed according to elasticity. The less elastic side receives the greater share.

Examples of Taxes and Subsidies

Tax on cigarettes: Goal: reduce smoking, collect revenue Demand is inelastic (addiction) Most of the tax falls on smokers Quantity decreases moderately Substantial budget revenues

Tax on carbon emissions: Goal: reduce pollution Increases the price of “dirty” production Stimulates shift to clean technologies Pigouvian tax — internalizes external effects

Subsidies for electric vehicles: Goal: spur “green” technologies Lowers the price for buyers Increases sales Question: who really gets the subsidy — buyers or producers?

Agricultural subsidies: Support for farmers Increase production Lower prices for consumers Distort international trade

Optimal Taxation Ramsey rule: to minimize DWL, taxes should be higher on goods with inelastic demand/supply. Distortions are smaller there.

Paradox: this implies taxing necessities (inelastic demand) — politically unacceptable, though economically efficient.

Trade-off: efficiency vs fairness. Progressive taxation creates more distortions but is considered fairer.

For Investors Tax changes impact companies:

Who bears the burden — the company or consumers? Depends on elasticity.

Companies with pricing power (inelastic demand) can pass taxes on. Competitive industries — the tax falls on margins.

Subsidies create opportunities: Subsidized industries receive an artificial boost. Risk: subsidies may be repealed.

Analysis: how dependent is the company on subsidies?