Types of Taxes: Direct and Indirect

Taxation

• Direct tax: a tax levied on income and wealth, where the income receiver is directly liable to pay the tax.
• Indirect tax: a tax paid by consumers when buying a product, but the seller is liable to pay the tax.
• There are two types of indirect taxes:
  • Specific tax: a per-unit tax of a fixed amount on quantity/volume/weight.
  • Ad Valorem tax: a tax expressed as a percentage of the purchase price.

The Effect of a Specific Tax on Market Equilibrium

• An excise tax shifts the supply curve to the left, indicating that producers require more revenue to cover the indirect tax.
• The market price rises by the full amount of the tax if demand is completely price inelastic or supply is completely price elastic.

The Incidence of Taxation

• The proportion of the tax burden paid by consumers and sellers depends on the elasticity of demand and supply.
• If the price elasticity of demand exceeds the price elasticity of supply, sellers' share of the tax burden exceeds buyers' share.
• Conversely, if the price elasticity of demand is less than the price elasticity of supply, sellers' share of the tax is less than buyers' share.

Subsidy

• A subsidy is a payment by the government to producers, reducing the costs of supplying a commodity.
• The effect of a subsidy is to reduce the market price and increase the quantity supplied.
• The supply curve shifts to the right, and the price buyers pay differs from the price sellers get.

Maximum Price Legislation

• A maximum price ceiling makes it illegal for sellers to charge more than a specific maximum price.
• The effect of a maximum price ceiling is to create a shortage of supply relative to demand.
• The extent of the shortage depends on the price elasticities of demand and supply and the difference between the market equilibrium price and the controlled price.
• The ceiling price allows some people to buy at a lower price, but it reduces the total quantity supplied and creates a shortage.
• The government may use non-price rationing devices such as "first come, first served" or favoured customers to allocate the limited supply.

The Effect of Maximum Price Controls on Consumers' and Producers' Surpluses

• The net effect on consumers' surplus can be positive or negative.
• Producers lose producer surplus, resulting in a net loss of total surplus.
• The loss to producers is not offset by the gain to consumers, resulting in a deadweight loss.

Application of Maximum Price Legislation - Rent Controls

• Rent controls limit the rent a landlord can charge tenants.
• In the short run, the supply curve is very inelastic, but in the long run, the supply contracts as property is allowed to deteriorate or is sold to owner-occupiers.
• The excess demand creates black market pressures, and landlords may evict existing tenants to collect new entrance fees.

Minimum Price Legislation

• A minimum price floor sets a price below which prices are not allowed to fall.
• The consequences of setting a minimum price above the market equilibrium price are an excess supply and a shortage of accommodation.
• The government has to restrict output, and the type of product is important in setting the minimum price.

The Effect of Minimum Price Controls on Consumers' and Producers' Surpluses

• The effect on the aggregate economic welfare of consumers and producers depends on the reaction of producers.
• The possible effects of a price floor on consumers' surplus and producers' surplus are:
  • Suppliers producing only what can be sold, avoiding a surplus.
  • Suppliers increasing output levels, buying up the unsold output.
  • Government buying up the unsold output.

Application of Minimum Price Legislation - The Common Agricultural Policy

• The agricultural industry has experienced a long-run downward trend in agricultural prices compared to the prices of manufactured goods.

• The Common Agricultural Policy (CAP) sets target prices to guarantee even the less efficient farmers of the EU a reasonable income.

• The CAP ensures a minimum price for agricultural products, leading to a surplus of production.### The Common Agricultural Policy (CAP)

• The CAP has advantages for farmers, including:

  • Rising incomes through annual price increases
  • Keeping farmers on the land, reducing rural unemployment and maintaining political support

• The CAP has benefits for consumers, including:

  • Increased food supplies and self-sufficiency in staple agricultural products
  • Improved variety and choice of food products

• However, the CAP has also led to:

  • Higher food prices within the EU, above world prices
  • Significant costs to finance, making up 49.3% of EU spending in 1993
  • Subsidies for food surpluses sold on world markets

CAP Reforms

• Producers are paid to take land out of production in 'set aside' schemes
• Farmers may focus on more productive land, potentially mitigating the effects on crop yields
• There is encouragement for environmentally friendly practices and financial help for farmers leaving the land
• The aim is to reduce the CAP's share of the EU budget, freeing up funds for other purposes

Minimum Wage Legislation

• Effective minimum wage laws must be set above the market equilibrium wage
• This can lead to unemployment, as shown in Figure 4.13
• The employment effects of minimum wage laws are mixed, but often reduce opportunities for teenagers
• Minimum wage laws have a negligible effect on adults, as most earn above the minimum wage
• Non-compliance and reduction of fringe benefits can also mitigate the effects on employment