Taxes and Subsidies: Ka-Fu Wong

Taxes and Subsidies
Ka-fu Wong
University of Hong
Kong
1
Policy Shapes Incentives and Behavior
o In the United States, not only are more children born in
late December than in early January, but also the extra
births appear to be clustered among those who have the
most to gain from a tax deduction.
Unless you’re a cynic, or an economist, I realize

you might have trouble believing that the
intricacies of the nation’s tax code would impinge
on something as sacred as the birth of a child.
But it appears that you would be wrong.
- David Leonhardt The New York Times
Dickert-Conlin, Stacy and Amitabh Chandra (1999) “Taxes and the Timing of Births” Journal of
Political Economy, Vol 107, No. 1, pp. 161-177.
2
Many types of taxes
o Income tax, profit tax, property tax, consumption tax, sales tax, tariff (tax
on international trade), etc.
o A lump-sum tax is a tax in which the taxpayer is assessed the same

amount regardless of circumstance.
o A per unit tax is a tax that is defined as a fixed amount of charges per
unit of a good or service sold.
o It is independent of the price of the good or service.
o A sales tax is a tax that is defined as a percentage of the sales of

(expenditure on or revenue from) certain goods and services.
o The tax collection increases with quantity and the prices of goods or
services.
3
Basic insight: tax on buyers
o John is willing to pay $10 for an apple. The price is $4 per apple.
John will buy the apple and gain a consumer surplus of $6
( $10-4 = $6 )
o If the government imposes $1 per unit tax on apple consumption,

John will have to pay $5 ( = 4+1 ) to consume an apple. He will
continue to buy the apple because consumer surplus is positive
( $10-5 = $5 = $6-1 ).
o If the government imposes $2 per unit tax on apple consumption,

John will have to pay $6 ( = 4+2 ) to consume an apple. He will
continue to buy the apple because consumer surplus is positive
( $10-6 = $4 = 6-2 ).
4
WTP Price Tax Payment CS Purchase?

$10 $4 $0 $4 $6 
$10 $4 $1 $5 $5 
$10 $4 $2 $6 $4 
$10 $4 $3 $7 $3 
$10 $4 $4 $8 $2 
$10 $4 $5 $9 $1 
$10 $4 $6 $10 $0 
$10 $4 $7 $11 -$1 
Note: WTP=Willingness To Pay, CS=Consumer Surplus
5
John is willing to pay $10 for an apple. The price is $4 per apple. If the
government imposes $t per unit tax on apple consumption, what is the
value of $t so that John will continue to consume an apple?
CS = WTP – total payment
Total payment = payment to the market (P) + payment to the govt (t)
 
6
John is willing to pay $10 for an apple. The price is $4 per apple. If the
government imposes $t per unit tax on apple consumption, what is the
value of $t so that John will continue to consume an apple?
CS = WTP to the market – payment to the market
WTP to the market = WTP – tax payment
 
When a $t per unit tax is imposed on buyers, buyer’s WTP to the

market falls by the amount of t.
7
o When a $t per unit tax is imposed on buyers, buyer’s WTP to the
market falls by the amount of t.
o Adopting the vertical interpretation of demand, when a $t per unit

tax is imposed on buyers, the demand curve will shift downward by
the amount of t.
8
Basic insight: tax on sellers
o Mary's cost of producing an apple is $5. The price is $9 per apple.
Mary will sell the apple and gain a producer surplus of $4 ( =9-5 ).
o If the government imposes $1 per unit tax on apple sales, Mary will
receive only $8 (=9-1) per apple. She will choose to sell the apple
because sales yield positive producer surplus
( $8-5=$3 = $4-1 ).
o If the government imposes $2 per unit tax on apple sales, Mary will
receive only $7 (=9-2) per apple. She will choose to sell the apple
because sales yield positive producer surplus
( $7-5=$2 = $4-2 ).
9
Price Cost Tax Receipt PS Sell?

$9 $5 $0 $9 $4 
$9 $5 $1 $8 $3 
$9 $5 $2 $7 $2 
$9 $5 $3 $6 $1 
$9 $5 $4 $5 $0 
$9 $5 $5 $4 -$1 
$9 $5 $6 $3 -$2 
Note: Receipt=amount received, PS=Producer Surplus

10
o Mary's cost of producing an apple is $5. The price is $9 per apple. If
the government imposes $t per unit tax on apple sales, what is the
value of $ t so that Mary will continue to sell an apple?
PS = Receipt – Production cost
Receipt= market price (P) - payment to the govt (t)
 
11
o Mary's cost of producing an apple is $5. The price is $9 per apple. If
the government imposes $t per unit tax on apple sales, what is the
value of $ t so that Mary will continue to sell an apple?
PS = Market price – Cost of selling the unit
Cost of selling the unit = Production cost + payment to the govt (t)
 
When a $t per unit tax is imposed on sellers, seller’s cost of selling the
unit to the market increases by the amount of t.
12
o When a $t per unit tax is imposed on sellers, seller’s cost of selling
the unit to the market increases by the amount of t.

tax is imposed on sellers, the supply curve will shift upward by the
amount of t.
13
Benchmark – an unregulated market
Market of widgets
Supply:
Demand:
Rewrite
Supply:
Demand:
14
Benchmark
Market of widgets
Supply:
Demand:
At equilibrium, ,
Supply:
Demand:
15
Benchmark
(
CS=2500
PS=1250
T ES=3750
16
Per unit tax imposed on buyers
o A per unit tax of $3 is imposed on buyers.
tax is imposed on buyers, the demand curve will shift downward by
the amount of t.
Supply:
Willingness to pay to consume:
Willingness to pay to the market:
17
Adopting the vertical interpretation of

demand, when a $3 per unit tax is imposed on
buyers, the demand curve will shift downward
by the amount of $3.
18
At equilibrium, ,
Supply:
19
Equilibrium price is the price received

by the sellers.
20
CSurplus=1600
PSurplus=800
TaxRevenue=1200

T otalEconSurplus=3600
CSurplus: How much buyers are willing to pay to the market – how much buyers have to pay to the market
21
CSurplus=1600
PSurplus=800
TaxRevenue=1200

T otalEconSurplus=3600
CSurplus: How much buyers are willing to pay to consume – how much buyers have to pay in total
22
Welfare
Unregulated 3750
Tax on buyers 3600
Welfare loss (DWL) 150
23
To find welfare loss due to subsidy,

we only need to look at the
original supply and demand and
the new equilibrium quantity
under tax.
24
Tax burden
Unregulated 10 10 0
$3 per unit tax on buyers 12 9 3
Change in cost of consumption per unit +2
Change of receipt per unit -1
Buyer’s tax burden Seller’s tax burden
25
Perfectly inelastic supply and regular downward sloping demand
Price falls by the amount of per unit tax

by the sellers.
26
Tax burden
Unregulated 0
tax on buyers 3
Change in cost of consumption per unit 0
27
Perfectly elastic supply and regular downward sloping demand
No change in price!

by the sellers.
28
Tax burden
Unregulated 0
tax on buyers 3
Change of receipt per unit 0
29
Tax burden falls more on the one who are more price inelastic!!!
Unregulated 0
tax on buyers 3
Change in cost of consumption per unit 0
Unregulated 0
tax on buyers 3
30
Animation: how does elasticity affect the tax burden and welfare?
31
Per unit tax imposed on sellers
o Adopting the vertical interpretation of demand, when a $t per unit tax is
imposed on buyers, the demand curve will shift downward by the amount
of t.
Supply:
o A per unit tax of $3 is imposed on sellers.

o Adopting the vertical interpretation of supply, when a $t per unit tax
is imposed on sellers, the supply curve will shift upward by the
amount of t.
Marginal cost of production:
Marginal cost of selling to the market:
32
Adopting the vertical interpretation of supply,

when a $t per unit tax is imposed on sellers,
the supply curve will shift upward by the
amount of t.
33
At equilibrium, ,
Marginal cost of production:

34
The output is the same – regardless on

whom the government imposes the tax.
35
(
CS=1600
PS=800
TaxRev=1200
T ES=3600
The welfare distribution is the same – regardless
on whom the government imposes the tax.
PSurplus: The amount sellers receives by supplying a unit to the market

– the cost of supplying the unit to the market. 36
(
CS=1600
PS=800
TaxRev=1200
T ES=3600
The welfare distribution is the same – regardless
on whom the government imposes the tax.
PSurplus: The net amount sellers receive from supplying a unit (net of tax payment)
– the cost of producing the unit. 37
Welfare
Unregulated 3750
Tax on buyers 3600
DWL 150
The welfare loss is the same –

regardless on whom the government
imposes the tax.
38

under tax.
39
Tax burden
Unregulated 10 10 0
$3 per unit tax on sellers 12 9 3
The split of the tax burden is the same – regardless on whom the government
imposes the tax.
40
Perfectly inelastic demand and regular upward sloping supply
41
Tax burden
Unregulated 0
tax on buyers 3
42
43
Tax burden
Unregulated 0
tax on buyers 3
44
Tax burden falls more on the one who are more price inelastic!!!
Unregulated 0
tax on buyers 3
Unregulated 0
tax on buyers 3
45
Animation: how does elasticity affect the tax burden and welfare?
46
Regardless on whom the tax is imposed
E1: tax on sellers

E2: tax on buyers
Same price paid by the buyers.

Same price received by the sellers.
Same equilibrium quantity.

Same tax burden borne by the buyers.
Same tax burden borne by the sellers.
Same distribution of welfare across groups.
Same welfare loss due to tax.
47
Who produce and who consume?
o Who gets the good?
o Those with a higher valuation than the price paid by buyers.
Consumption is allocated to buyers with higher valuations.
o Who produces the good?

o Those with a lower cost of production than the price received by
sellers. Production is allocated to sellers with lower costs.
48
The Burden of Tax
o Who pays the tax? It depends on the relative price elasticities of
supply and demand.
o The less price elastic side of the market will pay the greater
share of a tax (bear more of the burden of a tax).
Imagine the buyers are sellers are chased by a lion (tax).

Those who run slower (more price inelastic) will be eaten up
(take up more of the tax burden).
49
The Burden of Tax
In a long-distance relationship, who will do more of the driving?

Does the “tax” fall more heavily to the more committed partner?
50
The Burden of tax
This pleasure boat seems like a good thing to tax…
Or not: The Omnibus Budget Reconciliation Act of 1990
applied a 10% federal luxury tax to the retail sale of
luxury goods like pleasure boats with a sales price above
$100,000. Expected tax revenue? $9 billion. Reality?
The federal luxury tax was repealed in 1993.
o Sales of boats down 52.7%;

o Net loss of 30,000 jobs;
o The federal government paid out > $7 million more in
unemployment benefits to those workers than it collected in
luxury tax revenues. 51
The Burden of a Tax
“You had to be an ignoramus to believe the luxury tax was
only going to soak the rich. The only people it hurt was
working people like myself,”
-Judy Ott, an assembly worker at the Viking Yacht Company’s
plant in New Jersey.
“All these people suffered needlessly because the

politicians in Washington needed a symbol to sell the
American people a new tax increase,”
- Viking’s co-founder Robert T. Healey.
52
The Burden of a Tax
o Health Insurance Mandates and Tax Analysis
o Mandates requiring employers to provide health
insurance to their workers may reduce wages if labor
supply is less elastic than demand for workers.
o Firms have incentives to replace workers with
machines
The impact differs across sectors because
o Some sectors can replace workers with
machine easier than the others.
(wage elasticity of demand for workers)
53
The Burden of a Tax
Who Pays the Cigarette tax?
Effective in discouraging smoking?
o State cigarette taxes:
o Demand for cigarettes is relatively inelastic but supply of
cigarettes to a given state is relatively elastic. The
impact of cigarette tax on quantity is supposed to be
big.
o Buyers are expected to take up most of the tax burden.
o But, buyers may shop across the border. And, if
manufacturers of cigarettes can easily dodge state taxes
(via smuggling), then it’s possible the tax will not
discourage smoking.
o National cigarette taxes:
o Supply of cigarettes to the whole nation is relatively
inelastic (when compared to that of individual states).
o No interstate tax-dodging, hence is more effective in
deterring smoking.
54
Welfare loss and Elasticity
o Welfare losses (Deadweight Losses) are Larger the bigger
the impact of tax on quantity transacted.
o The impact on quantity is bigger when

o The demand curve is more elastic
o The supply curve is more elastic
55
Wedge approach
E1: tax on sellers

E2: tax on buyers
Equivalence regardless on
whom the tax is imposed
+
PD - PS = t

Can solve the problem
without knowing on whom
the tax is imposed
56
Wedge approach
o Know: we must have Pd – Ps = 3 at equilibrium quantity.
Supply:
Demand:
Wedge:
57
Wedge approach
58
Subsidy
A subsidy is a reverse tax where the government gives money to
consumers (or producers).
o Most of the analysis and major conclusion are similar to the case of
tax.
59
Basic insight: subsidy on buyers
o John is willing to pay $10 for an apple. The price is $14 per apple. If
John consumes the apple, he will derive a consumer surplus of -$4
( =10-14 ). Of course, John will not consume the apple because zero
consumer surplus is better than negative consumer surplus ( -$4 ).
o If the government gives $1 per unit subsidy on apple consumption,

John will have to pay $13 ( =14-1 ) to consume an apple. If John
consumes the apple, he will derive a consumer surplus of -$3 ( =10-
13 = -$4+1 ). Thus, he will choose not to consume an apple.
o If the government gives $2 per unit subsidy on apple consumption,

John will have to pay $12 ( =14-2 ) to consume an apple. If John
consumes the apple, he will derive a consumer surplus of -$2 ( =10-
12 = -$4+2 ). Thus, he will not choose to consume an apple.
60
WTP Price Subsidy Payment CS Purchase?

$10 $14 $0 $14 -$4 
$10 $14 $1 $13 -$3 
$10 $14 $2 $12 -$2 
$10 $14 $3 $11 -$1 
$10 $14 $4 $10 $0 
$10 $14 $5 $9 $1 
$10 $14 $6 $8 $2 
$10 $14 $7 $7 $3 
Note: WTP=Willingness To Pay, CS=Consumer Surplus
61
John is willing to pay $10 for an apple. The price is $14 per apple. If
the government gives $ s per unit subsidy on apple consumption, what
is the minimum value of $ s so that John will choose to consume an
apple (i.e., a change of his decision).
CS = WTP – total payment
Total payment = payment to the market (P) – subsidy by the govt (s)
 
62
John is willing to pay $10 for an apple. The price is $14 per apple. If
the government gives $ s per unit subsidy on apple consumption, what
is the minimum value of $ s so that John will choose to consume an
apple (i.e., a change of his decision).
CS = WTP to the market – payment to the market
WTP to the market = WTP + subsidy
 
When a $ s per unit subsidy is imposed on buyers, buyer’s WTP to

the market rises by the amount of s.
63
o When a $ s per unit subsidy is imposed on buyers, buyer’s WTP to
the market rises by the amount of s.
o Adopting the vertical interpretation of demand, when a $s per unit

subsidy is imposed on buyers, the demand curve will shift upward
by the amount of s.
64
Basic insight: subsidy on sellers
If Mary sells the apple, she will get a producer surplus of -$6 ( =9-
15 ). Thus, she will choose not to sell.
o If the government imposes $1 per unit subsidy on apple sales, Mary

will receive only $10 (=9+1) per apple. She will not choose to sell
the apple because sales yield negative producer surplus
( $10-15=-$5 = -$6+1).
o If the government imposes $2 per unit subsidy on apple sales, Mary

will receive only $11 (=9+2) per apple. She will not choose to sell
the apple because sales yield negative producer surplus
( $11-15=-$4 = -$6+2).
65
Price Cost Subsidy Receipt PS Sell?

$9 $15 $0 $9 -$6 
$9 $15 $1 $10 -$5 
$9 $15 $2 $11 -$4 
$9 $15 $3 $12 -$3 
$9 $15 $4 $13 -$2 
$9 $15 $5 $14 -$1 
$9 $15 $6 $15 $0 
$9 $15 $7 $16 $1 
Note: Receipt=amount received, PS=Producer Surplus
66
If the government imposes $s per unit subsidy on apple sales, what
is the value of $ s so that Mary will sell an apple?
PS = Receipt – Production cost
Receipt= market price (P) + subsidy from the govt (s)
 
67
If the government imposes $s per unit subsidy on apple sales, what
is the value of $ s so that Mary will sell an apple?
PS = Market price – Cost of selling the unit
Cost of selling the unit = Production cost – subsidy from the govt (s)
 
When a $s per unit subsidy is imposed on sellers, seller’s cost of

selling the unit to the market decreases by the amount of s.
68
o When a $s per unit subsidy is imposed on sellers, seller’s cost of
selling the unit to the market decreases by the amount of s.

subsidy is imposed on sellers, the supply curve will shift downward
by the amount of s.
69
Per unit subsidy imposed on buyers
o A per unit subsidy of $3 is imposed on buyers.
subsidy is imposed on buyers, the demand curve will shift upward
by the amount of s.
Supply:
At equilibrium, ,
Supply:
70
Adopting the vertical interpretation of

demand, when a $s per unit subsidy is imposed
on buyers, the demand curve will shift upward
by the amount of s
71
Change of equilibrium
from E0 to E1
New equilibrium price:
Price received by the sellers
72
Change of equilibrium
from E0 to E1
New equilibrium price:

Price received by the sellers
Price paid by the buyers

= Price received by sellers - subsidy
73
Consumer surplus
CSurplus: How much buyers are willing to pay to the market

– how much buyers have to pay to the market 74
Consumer surplus
CSurplus: How much buyers are willing to pay to consume

– how much buyers have to pay (net of subsidy) 75
Producer surplus
76
Subsidy expenditure
77
Welfare loss due to subsidy
78
Increase in
consumer surplus +
producer surplus
79
Increase in
consumer surplus +
producer surplus
+
Compared to subsidy
expenditure

Welfare loss due to
subsidy
80
An animation of the welfare loss due to subsidy
81
we only need to look at the original
supply and demand and the new
equilibrium quantity under subsidy.
82
Per unit subsidy imposed on sellers
o A per unit subsidy of $3 is imposed on sellers.
subsidy is imposed on sellers, the supply curve will shift downward
by the amount of s.
Supply = Marginal cost of production:

Demand = Willingness to pay to consume:
At equilibrium, ,
Supply = Marginal cost of production:

Demand = Willingness to pay to consume:
83
84
85
86
87
88
89
90
91

under subsidy.
92
93
Wedge approach
94
Major results of subsidy
o Subsidy = Price Received by Sellers
– Price Paid by Buyers
oThe subsidy encourage more production and consumption.
95
Major results of subsidy
o Given a set of demand and supply, regardless on whom the subsidy is
imposed
o Same Price Received by Sellers, same price paid by buyers, and hence
same share of subsidy.
o Same increase in equilibrium quantity (production and consumption)
o Goods are produced by the producers with the lowest cost. Goods are
consumed by the consumers with the highest willingness to pay.
o Welfare loss because the subsidy encourage too much production and
consumption.
96
Water Subsidies in California
Who benefits most from the large agricultural water subsidy?
Farmers in California’s Central Valley typically pay $20-$30 an acre-foot for
water that costs $200-$500 an acre-foot
Hint: which is more elastic: demand or supply for cotton?
a) California cotton suppliers

b) California cotton buyers
Since supply is less elastic than demand,

suppliers will receive more of the benefit of
any subsidy.
97
Wage Subsidies
o To encourage employment of some disadvantaged workers, we can use
wage subsidies.
98
Wage Subsidies
A wage subsidy costs the government money but increases employment from
Qm to Qs (and reduces welfare payments)
Wage Supply of Labor
Wage received by
Workers: $12 b
The $4
Market Wage: subsidy
$10.50 a wedge
Wage paid by d
Firms: $8
Demand for Labor
Quantity
Qm Qs
of Labor
99
Justification for taxation: welfare perspective
Welfare is maximized when

the market is unregulated!!
100
o Unregulated market is the best – welfare maximized.
o Any distortion will cause welfare loss.

o Social Marginal Cost = Private Marginal Cost (supply)
o Social Marginal Benefit = Private Marginal Benefit (demand)

o all the costs of production are borne by the sellers and

o all the benefits of consumption goes to buyers.
101
o the costs of production are NOT all borne by the sellers and
o the benefits of consumption does NOT all go to buyers.

o Social Marginal Cost = Private Marginal Cost + External Cost
o Social Marginal Benefit = Private Marginal Benefit + External Benefit

o Unregulated market is NOT the best – welfare is NOT maximized.

o There EXISTS some regulation(s) that can improve the welfare.
To be discussed in more details in the chapter of Externality.

102
o When the market is not perfectly competitive, e.g., monopoly,
o Without regulation, welfare NEED NOT be maximized.
o There EXISTS some regulation(s) that can improve the welfare.
To be discussed in more details in the chapter of Monopoly.
103

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Taxes and Subsidies

Unless you’re a cynic, or an economist, I realize

o A lump-sum tax is a tax in which the taxpayer is assessed the same

o A sales tax is a tax that is defined as a percentage of the sales of

o If the government imposes $1 per unit tax on apple consumption,

o If the government imposes $2 per unit tax on apple consumption,

WTP Price Tax Payment CS Purchase?

CS = WTP – total payment

CS = WTP to the market – payment to the market

WTP to the market = WTP – tax payment

When a $t per unit tax is imposed on buyers, buyer’s WTP to the

o Adopting the vertical interpretation of demand, when a $t per unit

Price Cost Tax Receipt PS Sell?

Note: Receipt=amount received, PS=Producer Surplus

PS = Receipt – Production cost

Receipt= market price (P) - payment to the govt (t)

PS = Market price – Cost of selling the unit

o Adopting the vertical interpretation of demand, when a $t per unit

Adopting the vertical interpretation of

Equilibrium price is the price received

To find welfare loss due to subsidy,

Buyer’s tax burden Seller’s tax burden

Price falls by the amount of per unit tax

Equilibrium price is the price received

Buyer’s tax burden Seller’s tax burden

Equilibrium price is the price received

Buyer’s tax burden Seller’s tax burden

Perfectly elastic supply and regular downward sloping demand

o A per unit tax of $3 is imposed on sellers.

Adopting the vertical interpretation of supply,

Marginal cost of production:

The output is the same – regardless on

PSurplus: The amount sellers receives by supplying a unit to the market

The welfare loss is the same –

To find welfare loss due to subsidy,

Buyer’s tax burden Seller’s tax burden

Buyer’s tax burden Seller’s tax burden

Buyer’s tax burden Seller’s tax burden

Perfectly elastic supply and regular downward sloping demand

E1: tax on sellers

Same price paid by the buyers.

o Who produces the good?

Imagine the buyers are sellers are chased by a lion (tax).

In a long-distance relationship, who will do more of the driving?

The federal luxury tax was repealed in 1993.

o Sales of boats down 52.7%;

“All these people suffered needlessly because the

o The impact on quantity is bigger when

E1: tax on sellers

o If the government gives $1 per unit subsidy on apple consumption,

o If the government gives $2 per unit subsidy on apple consumption,

WTP Price Subsidy Payment CS Purchase?

CS = WTP – total payment

CS = WTP to the market – payment to the market

WTP to the market = WTP + subsidy

When a $ s per unit subsidy is imposed on buyers, buyer’s WTP to

o Adopting the vertical interpretation of demand, when a $s per unit

o If the government imposes $1 per unit subsidy on apple sales, Mary

o If the government imposes $2 per unit subsidy on apple sales, Mary

Price Cost Subsidy Receipt PS Sell?

PS = Receipt – Production cost

Receipt= market price (P) + subsidy from the govt (s)