EFFECT OF TAXES AND SUBSIDIES ON PRICE

Taxes and subsidies have the effect of shifting the quantity and price of goods.
A marginal tax on the production of a good will shift the supply curve to the left until the vertical distance between the two supply curves is equal to the per unit tax; when other things remain equal, this will increase price paid by the consumers (which is equal to the new market price) and decrease the price received by the producers. Alternatively, a marginal tax on consumption will shift the demand curve to the left; when other things remain equal, this will increase the price paid by consumers and decrease the price received by producers by the same amount as if the tax had been imposed on the producers, although in this case, the price received by the producers would be the new market price. The end result is that no matter who is taxed, the prices producers and consumers face will be the same.
Marginal subsidies on production will shift the supply curve to the right until the vertical distance between the two supply curves is equal to the per unit subsidy; when other things remain equal, this will decrease price paid by the consumers (which is equal to the new market price) and increase the price received by the producers. Alternatively, a marginal subsidy on consumption will shift the demand curve to the right; when other things remain equal, this will decrease the price paid by consumers and increase the price received by producers by the same amount as if the subsidy had been imposed on the producers, although in this case, the new market price will be the price received by producers. The end result, again, is that no matter who is subsidized, the prices producers and consumers face will be the same.
Depending on the price elasticities of demand and supply, who bears more of the tax or who receives more of the subsidy may differ. Where the supply curve is more inelastic than the demand curve, producers bear more of the tax and receive more of the subsidy than consumers as the difference between the price producers receive and the initial market price is greater than the difference borne by consumers. Where the demand curve is more inelastic than the supply curve, the consumers bear more of the tax and receive more of the subsidy as the difference between the price consumers pay and the initial market price is greater than the difference borne by producers.
The effect of this type of tax can be illustrated on a standard supply and demand diagram. The price consumers pay is denoted by Pc and the price producer receives by Pp. The consumer's price will be the amount of the per unit tax above the producer's price. Since the consumer is willing to buy less at the higher price and the producer is willing to sell less at a lower price the quantity will move to quantity Qt which is lower than the equilibrium quantity of Qe.
Taxes and subsidies also have effects on investments and share prices. Embedded taxes within supply costs (e.g. tax on labor costs) will reduce the amount of capital that can be purchased with $1 of investment, whereas a subsidy will have the opposite effect, allowing $1 of investment to purchase more capital. Embedded taxes in supply prices are bad for business because it means that they have to borrow more money to finance a project with an given expected amount of return, while the opposite is true when supply prices are reduced through subsidies (or through a competitive market).

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See also

See also

★ excess burden of taxation

★ supply and demand

★ Tax incidence