Econs Unit 3 - The Impact and Incidence of Taxes and Subsidies - PDF

# 13 The Impact and Incidence of Taxes ## 13.1 The Impact and Incidence of Specific Indirect Taxes * **Ad valorem taxes** are a proportion or percentage of the price charged by the retailer. VAT in Kenya or Mauritius or a GST as charged in Canada and New Zealand are typical examples. The final pri...

# 13 The Impact and Incidence of Taxes ## 13.1 The Impact and Incidence of Specific Indirect Taxes * **Ad valorem taxes** are a proportion or percentage of the price charged by the retailer. VAT in Kenya or Mauritius or a GST as charged in Canada and New Zealand are typical examples. The final price paid by consumers is inclusive of such taxes. The tax element may be included in the published retail price or, in cases where the GST is on everything, added to the price at the final transaction stage. * **Specific taxes** are in the form of a fixed amount per unit purchased. For example, specific taxes are widely used to tax fuel. The tax is based on a measurable quantity, such as per litre. The final price includes this tax. Indirect taxes are widely used to discourage the production and consumption of demerit goods such as cigarettes and high-sugar sports drinks. These taxes tend to be passed on to consumers through increased prices in the market, although technically they are imposed on the producer. When an indirect tax is imposed, this tax must be paid to the government by retailers, wholesalers, manufacturers and other providers of taxable goods and services. This means that a business requires a price that is higher than the original price by the amount of the tax. With a specific tax, this is represented by a shift to the left of the supply curve by the amount of the tax. Figure 13.2 shows that: * the market price is now higher at P₁ compared to the previous equilibrium price of P * the quantity traded is less at Q1. ## 13.2 The Impact and Incidence of Subsidies Another form of government intervention in the market is through the provision of subsidies. These are direct payments made by governments to the producers of goods and services. Subsidies may be provided for many reasons including: * to keep down the market prices of essential goods * to encourage greater consumption of merit goods * to contribute to a more equitable distribution of income * to provide services that would not be provided by the free market * to raise producers' income, especially in the case of farmers * to provide an opportunity for exporters to sell more goods * to reduce dependence on imports by paying subsidies to domestic producers of close substitutes. When paid to a producer, a subsidy has the opposite effect of an indirect tax - it is the equivalent of a fall in costs for the producer and results in a rightward shift in the market supply curve. This is shown in Figure 13.4. Conversely, a reduction in a subsidy payment shifts the supply curve to the left. Figure 13.4 shows that introducing a subsidy in the market results in a fall in price from P to P₁ and an increase in the quantity traded from Q to Q1. This is the usual effect on the market when governments pay money to producers. ## 13.3 The Direct Provision of Goods and Services Governments provide certain important services free of charge at the point of use or consumption. Such services are financed through the tax system. If these services are used equally by all citizens, then those on lowest incomes gain most as a percentage of their income, thereby lowering inequality. The two most common instances of direct provision are merit goods and public goods (see Sections 6.3 and 6.4). Merit goods, such as healthcare and education, are provided free in some but not all economies. A common model is for there to be part free provision, with other parts being paid for at the point of use. The healthcare and education markets are subject to various market failures. These failures, though, do not justify free provision to the consumer. The justification must be on the grounds of equity. The view is that everyone should have access to a certain level of healthcare and education regardless of income. This means that where these services are provided universally free, they are the same as universal benefits. The characteristics of public goods mean that they will not be provided by the market mechanism. Neither will consumers be willing to pay for them. The only way in which they can be provided is directly by the government and paid for out of tax revenue. A frequent criticism is that this leads to inefficiency, with costs higher than what would have been the case in a competitive market. There are major differences in the direct provision of goods and services between economies, for example in healthcare provision. The UK has had a free National Health Service for more than 70 years; in contrast, free health care in the USA is limited. Those who can afford to pay are obliged to take out medical insurance. In most low-income countries, Cuba being a notable exception, a charge is usually made for most types of healthcare provision. This is especially the case in many countries in sub-Saharan Africa, where only a very basic system of healthcare is provided free of charge. ## 13.4 Maximum and Minimum Prices Market failure can occur where the price of a good in the free market is too high. This can prompt the government to pass legislation to impose a maximum price on a particular good or service. This is seen as a way of assisting families on low incomes, reducing inequalities in income or in recognition that the wider benefits of consuming a particular product are not fully appreciated. Maximum price controls or price ceilings are only valid in markets where the maximum price imposed is below the normal equilibrium price as determined in a free market. This means that the price that can be legally charged by sellers must not be any higher. Governments use legislation to enforce maximum prices for: * staple food items such as rice and cooking oil * petrol and diesel fuel * rents in certain types of housing * services provided by utilities, such as water, gas and electricity * transport fares, especially where a subsidy is being paid. Suppose the government passes legislation to impose a maximum price for cooking oil. A problem arises because if prices are forced down, producers of cooking oil are only willing to supply Q1, leading to a shortage in the market. Figure 13.7 indicates that at the maximum price of P1, production is not sufficient to satisfy everyone who wishes to buy the product. This is because the lower price makes cooking oil more affordable and Q2 is now demanded. Some consumers who bought OQ1 of cooking oil when its price was higher are now better off due to the lower price; others are not, since the product is not available. The extent of the shortage is Q2 minus Q1 in Figure 13.7. Consequently, as the price cannot rise, the available supply has to be allocated in some other way. The most likely way is by means of queuing, a common form of control in the former planned economies of Central and Eastern Europe. Rationing is another means of restricting demand – but this inevitably leads to an informal or underground market for the products involved, with consumers then having to pay inflated prices well above the maximum price. Such markets inevitably arise when there are dissatisfied people who have not been able to buy the goods they want because not enough has been produced. The direct provision of goods and services is a controversial issue. The main criticism is that the market overprovides, especially where no direct charge is made. Resources are not allocated efficiently. If a charge is made or introduced, demand is likely to fall. It can also be argued that many consumers could afford to pay a charge, so reducing the tax burden or allowing the funding saved in this way to be put to alternative uses. ## 13.5 Buffer Stock Schemes In Sections 7.1 and 10.2 it was explained how prices in agricultural markets can be unpredictable (volatile) particularly due to changes in supply. A buffer stock scheme is designed to smooth price rises and falls by buying and selling stocks of products depending on market conditions. In general terms, buffer stock schemes combine the principles of minimum and maximum price controls. A buffer stock scheme starts by setting a minimum price for a particular product, say potatoes. If the market price looks like going below this minimum, the buffer stock scheme will buy up stocks of potatoes from growers. These will be stored in warehouses. This action should raise the price of potatoes since supply in the market has fallen. The scheme can also set a maximum price. The effect will be to increase supplies from growers which in time will see a reduction in the price of the product. For many years, the European Union's (EU) Common Agricultural Policy (CAP) was an example of this type of intervention. The CAP was heavily criticised for its inefficiency. This resulted in CAP focusing instead on implementing structural reform to make agricultural production more efficient. It is also the case that producers are likely to be inefficient; firms with high costs have little incentive to reduce costs since the high minimum price protects them from lower-cost competitors. As with maximum price control, there is a danger that an informal market will develop, especially for products like imported cigarettes. The high rate of indirect taxation and high minimum price mean these products are attractive for non-market trading. Consumers will be more than happy to buy from dealers offering these goods at less than the regulated minimum price. ## 13.6 Provision of Information In Section 6.4 it was explained how information failure can result in the under consumption of merit goods and the over consumption of demerit goods. It therefore seems logical for the government itself to use information provision as a form of direct intervention. A few examples are: * compulsory information on cigarette packets warning of the dangers of smoking * public health announcements and campaigns * advice on non-prescription medicines * nutrition and allergy information on food packaging. # 14 Policies to Redistribute Income and Wealth ## 14.1 Income and Wealth You need to be aware of the difference between income and wealth. Income is the reward for the services of a factor of production (see Section 3.1). For labour, income is paid in wages, salaries and bonuses. For other factors of production, income takes the form of rent, interest and profits. Income is a flow concept. This is because the returns to the various factors of production are variable over any given period of time. Wealth describes the stock of assets that someone has built up over time, for example businesses, property, shares, gold and antiques. These assets are there to provide security and in some cases, an income stream for the future. Table 14.1 shows the wealth that had been accumulated by 2019 by the top three wealthiest people in China, India and Malaysia. As you can see from Table 14.1, most of the wealth has come from firms. This is different from some high-income countries, such as the UK and the countries of the European Union, where much of the wealth has been inherited from past generations of families. ## 14.2 Measuring Income and Wealth Inequality The Gini coefficient is a numerical measure of the extent of income inequality in an economy. If the income distribution in an economy is equal, the Gini coefficient will have a value of 0. At the other extreme, if all income accrues to just one person, then the Gini coefficient will be 1. Both extremes do not occur in the real world. The norm is for Gini coefficients to be somewhere between the values of 0 and 1. A Gini coefficient of 0.3 therefore indicates a more equal distribution of income than a coefficient of 0.5. Table 14.2 contains some examples from various types of economy. (The data in this table is shown as percentages: 100% represents full inequality). ## 14.3 Economic Reasons for Inequality of Income and Wealth Economists agree that inequality of income and wealth acts as a barrier to economic growth and development. There are many reasons for this inequality, some economic, others social, cultural and political. Below are some economic reasons for inequality: * a lack of formal employment opportunities, particularly for young people, but also for those with professional skills * poor vocational training, which means that local industries cannot obtain the labor needed to maintain a viable operation in national and international markets * a lack of investment in the education and health sectors, which holds back human capital needed to promote economic growth * poor infrastructure such as roads, railways, power and water supplies * a low rate of savings, which holds back private and public sector investment * the inability of many people to obtain credit to fund small businesses and improved personal education. ## 14.4 Policies to Redistribute Income and Wealth Governments may use a range of policies to reduce inequality in the distribution of income and wealth. Most governments seek to reduce income inequality; there may also be policies to redistribute wealth. Many of the policies depend on funds generated from tax revenue for their implementation and regulation. The collection of taxes causes serious difficulties in most low-income countries and many middle-income countries, where the informal economy is huge with only a very small percentage of the population paying direct as opposed to indirect taxes. Corruption and tax evasion (where people deliberately do not pay tax) are also commonplace. This hinders the ability of governments to successfully implement policies that redistribute income and wealth. # 12 Government Intervention in Markets ## 12.1 What is Market Failure? When markets work efficiently, they produce the best allocation of resources. This is an ideal situation. In reality, as economies grow and become more complex, markets do not always operate in the way that is set down by economic theory. When this happens, there is market failure. Market failure is an inefficient allocation of goods and services in the market. In this case, the free market mechanism does not make the best use of scarce resources. Market failure occurs when the price mechanism fails to take into account all of the costs and benefits that are necessary to produce or consume a product. Markets are not perfect due to inefficient production and consumers not having perfect information to be able to make informed choices. Microeconomics has many situations where market failure occurs, and requires government intervention. These situations include: * lack of public goods (see Section 6.3) * underproduction of merit goods (see Section 6.4) * overconsumption of demerit goods (see Section 6.4) * information failure (see Section 6.4). ## 12.2 How Governments Intervene in Markets **Addressing the Non-Provision of Public Goods** Public goods include the police force, national defence, fire protection, street lights, non-toll roads and flood control systems. The nature of public goods is that they are consumed collectively (by everyone) and their use by one person does not make the public good less available to others. The free rider problem means that people can enjoy the use of a public good without contributing towards its cost. A lighthouse clearly matches the two characteristics of public goods. It is a good example to include in an answer for this reason. It is therefore difficult, if not impossible, to make a direct charge for consuming a public good. It is obvious that the private sector would not be interested in providing public goods as there is no opportunity to make a profit from their investment. When left to the free market, public goods would not be provided despite the benefits they give to those who consume. It is for this reason that public goods have to be funded by the government out of tax revenue and provided free of charge for the public. Opportunity cost is an issue since the funding for public goods is competing with other types of government spending, often in countries with a modest tax base. **Addressing the Overconsumption of Demerit Goods** Demerit goods are ones that are considered undesirable for consumers and that tend to be over provided, therefore over consumed in the free market. The main reason for this is that consumers invariably lack full and proper information on demerit goods such as cigarettes and tobacco. This is why governments have increasingly intervened in this particular market. Over the past ten years or so, in many countries, regulations banning smoking in public places have been introduced. Manufacturers may be required to put written warnings and graphic photographs on packaging explaining the dangers of smoking. Governments reason that measures such as this will help protect the health and well-being of the population; other reasons are to promote a more productive workforce and to make savings in the healthcare budget through treating fewer patients with smoking-related complaints. These reasons have tended to be more relevant than the loss of tax revenue through reduced sales of tobacco products.