Taxes and Subsidies

Dr. Varadurga Bhat

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Taxes, Subsidies and Their Distribution

● Effects of Indirect taxes (taxes on goods)

● Specific Tax: Per unit tax; Tax is imposed per unit of the product sold
● Shifts the supply function vertically upwards by the amount of the tax.
● Ad valorem Tax: A proportionate tax; A percentage of the price of the
good
● changes the slope of the supply function. The slope will become steeper
E.g VAT, GST

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Effect of Specific Tax on Market Equilibrium

● Two concerns that arise when a tax is imposed on a good
a. How does the imposition of the tax affect the equilibrium price and
quantity of the good?
b. What is the distribution (incidence) of the tax, that is, what percentage
of the tax is paid by consumers and producers respectively?
A specific tax
● Shifts the supply curve upwards parallelly by the amount of tax
● Changes the intercept of the supply function, slope remains the same
● Increases the price of the product and reduces the equilibrium quantity
● The consumer always pays the equilibrium price.
● The supplier receives the equilibrium price minus the tax (Ps-T) or the
minimum price the seller is now willing to accept for quantity Qs is
Ps + T.

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Example
The demand and supply functions for a good are given as
Demand function: Pd = 100 - 0.5Qd
Supply function: Ps = 10 + 0.5Qs
(a) Calculate the equilibrium price and quantity.
(b) Assume that the government imposes a fixed tax of $6 per unit sold.
(i) Write down the equation of the supply function, adjusted for tax.
(ii) Find the new equilibrium price and quantity algebraically and
graphically.
(iii) What is the price paid by the buyer?
(iv)What is the price received by the seller?
(v) Outline the distribution of the tax, that is, calculate the tax paid by the
consumer and the producer.
(vi) What is the tax revenue collected by the government?

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(a). Equilibrium price=P=$55

Equilibrium quantity=Q=90 units
● The price that the consumer pays is equal to the price that the
producer receives.
(b)
● (i) The tax of $6 per unit sold means that the effective price received
by the producer is (Ps — 6). i. e 𝑃𝑠— 𝑇 = 10 + 0.5𝑄𝑠. The equation
of the supply function adjusted for tax is
● P𝑠’=Ps+T
● P𝑠’=10+0.5Qs+6
● Ps’ =16 + 0.5Qs
● The supply function is translated vertically upwards by 6 units (with a
corresponding horizontal leftward shift).

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● (ii) The new equilibrium price and quantity are calculated by equating the
original demand function and the new supply function adjusted for tax
Pd= Ps’
100-0.5Q= 16 + 0.5Q
Q = 84
● Substitute the new equilibrium quantity, Q = 84 into either demand or supply
equation, to get the value of P
● Substituting the new equilibrium quantity, Q = 84 into the demand equation
and solving for the new equilibrium price:
P = 100 - 0.5(84)
P=58
(iii) The consumer always pays the equilibrium price, therefore the consumer
pays $58, an increase of $3 on the original equilibrium price with no tax,
which was $55.

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● The producer receives the new equilibrium price, minus the tax, (Ps’ – T) so
the producer receives $58 — $6 = $52, a reduction of $3 on the original
equilibrium price of $55.
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒
● Buyer’s burden of the tax= × 100
𝑡𝑎𝑥 𝑎𝑚𝑜𝑢𝑛𝑡
58−55
● = × 100 = 50%
6
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑒𝑙𝑙𝑒𝑟 ′ 𝑠 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑝𝑟𝑖𝑐𝑒
● Seller’s burden of the tax amount= × 100
𝑡𝑎𝑥 𝑎𝑚𝑜𝑢𝑛𝑡
55−52
● = × 100=50%
6
● (Seller’s share=100 - buyer’s share)
● In this example, the tax is evenly distributed between the consumer
and producer. The reason is the slope of the demand function is equal to the
slope of the supply function (ignoring signs).
● Changes in the slope of either the demand or supply functions will alter this
distribution.

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Summary
● Demand Function: Qd=a-bP
● Supply function: Qs= -c +dP
● If a specific Tax=T is imposed on the good, the new supply function
will be
● Qs’= - c +d(P-T)

● If the inverse supply function is given, the tax-adjusted supply function

will be of the form Ps’=Ps+T, where Ps is the original equation of the
supply function
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Illustration of the Effect of Specific Tax on Market

Equilibrium

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Effect of a Per Unit Subsidy on Market Equilibrium

a. How does the subsidy affect the equilibrium price and quantity of the
good?
b. how the benefit of the subsidy is distributed between the producer and
consumer.
A subsidy per unit sold
● Shifts the supply curve downwards parallelly by the amount of subsidy
● Changes the intercept of the supply function, slope remains the same
● Reduces the price of the product and increases the equilibrium
quantity
● The consumer always pays the equilibrium price.
● The supplier receives the equilibrium price plus subsidy (Ps+S) the
minimum price the seller is now willing to accept for quantity Qs is
Ps - S.

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Example
The demand and supply functions for a good ($ P per ton of potatoes) are
given as
Demand function: Pd = 450 - 2Qd
Supply function: Ps = 100 + 5Qs
(a) Calculate the equilibrium price and quantity.
(b) The government provides a subsidy of $70 per unit (ton) sold:
(i) Write down the equation of the supply function, adjusted for the subsidy
(ii) Find the new equilibrium price and quantity algebraically and graphically
(iii) What is the price paid by the buyer?
(iv)What is the price received by the seller?
(v) Outline the distribution of the subsidy, that is, calculate how much of the
subsidy is received by the consumer and the supplier
(vi) What is the burden on the government?

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Solution
(a). Equilibrium price=P=$350
Equilibrium quantity=Q=50 units
(b)
(i) With a subsidy of $70 per unit sold, the producer receives (Ps + 70) for each
product sold. i. e Ps+S =100+5Q. The equation of the supply function adjusted for
subsidy is
● Ps‘= 100 + 5Q – 70
● Ps‘ = 30 + 5Q
● The supply function is translated vertically downwards by 70 units.
(ii) The new equilibrium price and quantity are calculated by equating the original
demand function and the new supply function adjusted for the subsidy
Pd = (Ps + subsidy)
450 - 2Q = 30 + 5Q
Q=60

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● Substitute the new equilibrium quantity Q = 60 into either demand or

supply equation, we get the value of P
● Substitute the new equilibrium quantity Q = 60 into demand equation
and solve for the new equilibrium price:
P = 450 - 2Q
P = 450 - 2(60)
P=330
● (iii) The consumer always pays the equilibrium price, therefore, the
consumer pays $330, a decrease of $20 on the equilibrium price with
no subsidy ($350). This means that the consumer receives 20/70 of
the subsidy.
● The producer receives the equilibrium price, plus the subsidy, so the
producer receives $330 + $70 = $400, an increase of $50 on the
original price of $350. The producer receives 50/70 of the subsidy.

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𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒

● Buyer’s share of the subsidy benefit= × 100
𝑠𝑢𝑏𝑠𝑖𝑑𝑦 𝑎𝑚𝑜𝑢𝑛𝑡
350−330
● = × 100 = 28.57%
70
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑛𝑒𝑡 𝑝𝑟𝑖𝑐𝑒
● Seller’s share of the subsidy benefit= × 100
𝑠𝑢𝑏𝑠𝑖𝑑𝑦 𝑎𝑚𝑜𝑢𝑛𝑡
400−350
● = × 100=71.42%
70
● (Seller’s share=100 - buyer’s share)
● In this case, the subsidy is not evenly distributed between the consumer and
producer; the producer receives a greater fraction of the subsidy than the
consumer. Because the slope of the supply function is greater than the
slope of the demand function (ignoring signs).
● Subsidy burden on the govt = Quantity sold × subsidy per unit
● = 60 × 70 =$420

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Summary
● Demand Function: Qd=a-bP
● Supply function: Qs= -c +dP
● If a subsidy =S is imposed per unit on the good sold, the new supply
function will be
● Qs’= - c +d(P+S)

● If the inverse supply function is given, the tax-adjusted supply function

will be of the form Ps’=Ps- S, where Ps is the original equation of the
supply function
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Illustration of the Effect of A Per Unit Subsidy on Market

Equilibrium

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Effect of Ad Valorem Tax on Market Equilibrium

● A proportionate tax
● Tax is not levied as a fixed amount T, but is levied as a fixed proportion, t,
of the supply price, Ps at which the unit is sold. For example, if t = 0.5 (or
50%) and Ps = $50, the seller has to pay tPs = 0.5 × 50 = $25 to the
government per unit sold. If the supply price falls to, say, $40, the tax falls
to 0.5 × 40 = $20 per unit sold.
● The rate of tax is constant, but the amount of the tax, per unit sold, varies
with the supply price.
● The tax creates a new, tax-modified, inverse supply function.
● As the sellers have to recover the additional amount of tPs on every unit
sold, the minimum price they are now willing to accept for quantity Qs is
Ps + tPs
● The new supply function adjusted for tax is Ps‘ = Ps + tPs
● That is, Ps‘ = Ps (1+t)
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Example
In a competitive market where the supply price (in $) is Ps = 3 + 0.25Qs
and demand price (in $) is Pd = 15 − 0.75Qd
The government imposes an ad valorem tax of 25% of the supply price.
a. Find the new equilibrium price and quantity.
b. What is the buyer’s price?
c. What is the sellers price
d. Outline the distribution of the tax.
e. What will be the tax revenue raised?

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Solution
● At equilibrium P= 6 and Q=12
● Ad valorem tax is 25%=0.25
● The new supply function adjusted for tax is Ps‘ = Ps (1+t)
● Ps‘= (3 + 0.25Qs )(1+0.25)
● The tax-modified supply curve is not parallel with the original supply
curve. Because the tax is levied as a constant proportion of the supply
price before tax. Therefore the amount of tax, which is the vertical
distance between the two supply curves, increases as the supply price
increases.
● The new equilibrium price and quantity are calculated by equating the
original demand function and the new supply function adjusted for the
tax
● That is, Pd = 15 − 0.75Qd = 3.75 + 0.3125Qs

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● P=7.0589 and Q=10.5882

● Consumer’s price =Market equilibrium price=$7.0589

𝑃𝑠 ′ 7.0589
● Producer’s price= = = $5.647
1+𝑡 1+0.25

● Tax amount= tPs

0.25× 5.647=1.412

𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒

● Buyer’s burden of the tax= × 100
𝑡𝑎𝑥 𝑎𝑚𝑜𝑢𝑛𝑡
7.0589−6
● = × 100 =75%
1.412

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𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑒𝑙𝑙𝑒𝑟 ′ 𝑠 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑝𝑟𝑖𝑐𝑒

● Seller’s burden of the tax amount= × 100
𝑡𝑎𝑥 𝑎𝑚𝑜𝑢𝑛𝑡

6−5.647
● = × 100=25%
1.412

● (or 100-Buyer’s burden)

● Government’s tax revenue=Q×tPs
● 10.5882 × 1.412 =$14.9505

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Illustration of the effect of Ad valorem Tax on Market

Equilibrium

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Tax on Buyers

● It would result in a tax-modified demand curve and a tax-inclusive

demand price.
● The tax-modified demand curve would lie below the original or pre-tax
demand curve, because buyers are now willing to pay less to the
sellers for any given quantity.

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Elasticity and Tax Incidence

● The distribution of the tax burden depends on the elasticity of demand
and supply.
● A tax burden falls more heavily on the side of the market that is less
elastic.
● Because the elasticity measures the willingness of buyers or sellers to
leave the market when conditions become unfavorable.
● When the good is taxed, the side of the market with fewer good
alternatives is less willing to leave the market and must, therefore,
bear more of the burden of the tax.

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Supply is Elastic, Demand is inelastic

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Supply is Inelastic, Demand is Elastic

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