Taxes and Subsidies

Difference between Taxes and Subsidies

How does the differences between taxes and subsidies affect the outcome of a policy? Taxes and subsidies are two financial mechanisms the government uses; we'll cover why these exist and what implications they have for the government, citizens, and businesses.

Taxes

Taxes are the mechanism by which governments collect funds from their constituents to provide public services and address market failures. Commonly taxes are the way to provide necessary structures that the market may struggle to provide universally; these things can range from public defense, police, firefighters, healthcare, mail services, and roads.

While government handling market failures is inefficient as it is not subject to competition, government-controlled markets aim to provide more socially equitable outcomes than productively efficient ones.

The majority of criticisms of taxes and government spending come from the non-universal benefits that the government provides; services vital to one aspect of a community may do nothing for another, who then see it as a waste of money.

However, all citizens benefit to some degree from the government's management of things like roads, weather events, and trash services. Services provided by the government save citizens time and effort that can be quantified, such as a shorter commute due to well-maintained and efficient roads.

Businesses benefit from government tax expenditures in various ways, whether providing support to their labor pool or infrastructure and roads for their business. While businesses are taxed heavily, it is common for them to receive some tax relief through loopholes.

Additionally, governments may address market fluctuations by providing subsidies that are paid for by taxation. The benefits we receive from taxation often aren't seen in the dollar value they provide us. Check out this example below to learn more.

Subsidies

Subsidies are a financial tool regulators use to address market failures. The collection of taxes pays for subsidies.

Commonplace areas that receive subsidies range from healthcare, unemployment assistance, fossil fuel, agriculture, and housing.

The government intervenes in these instances, as the free market does not always provide a low enough cost for enough citizens. Governments can provide subsidies through tax reduction, buying surplus, loans, or cash.

The most popular uses of subsidies worldwide protect food production and agricultural industries. Countries guard their food supply to maintain autonomy. Governments can pay farmers for each product which will lower prices for consumers, or provide low-interest loans to help farmers get through tough growing seasons.

These government interventions are bad for competition and disrupt the free market's natural efficiency. However, they may provide a more equitable and stable market, or at least they try to. Consumers benefit from subsidies paid to businesses directly; read this example to learn more.

Taxes and subsidies have many uses and far-reaching implications for all aspects of our economy. Part of an economist's job is to measure the effectiveness of these policies.

Effect of Tax and Subsidy on Supply and Demand

Let's establish the difference of outcome subsidies and taxes can have on supply and demand. Government intervention can alter outcomes in a marketplace; let's analyze these effects. Analyzing how a market responds to these policies will give a better framework to understand why they may be implemented and their intentions.

Tax and Subsidy Effect on Supply

Policies like taxes and subsidies can alter supply significantly; the difference occurs whether it's used to correct competitive forces or address externalities, the market will shift accordingly. Policies can affect supply whether they're placed on producers or consumers, as changes in demand will change the equilibrium between supply and demand.

Determinants of supply and taxes and subsidies

Determinants of supply are many factors that affect a firm's quantity and price supplied. Check out this list below to see major factors that affect supply.

• Price of a good - Price changes has a direct supply and demand response.

• Price of substitute goods - Changes in the price or quality of competing goods.

• Price of inputs - Changes in the cost of production.

• Competitive forces - The more competition in the market, the more sharply supply is affected.

• Technology - Changes in technology affect productivity and the cost of production.

When a subsidy is applied, this is a benefit to the suppliers, receiving either a reduction in cost or cash. Either way, the subsidy is distributed, and it will increase returns for producers. Producers supply a quantity where marginal revenue (MR) equals marginal cost (MC); the subsidy raises marginal revenue, allowing producers to increase to a higher quantity. On a graph, this would appear as a rightward shift in the supply curve.

When a tax is imposed on suppliers, this increases their operating costs which will limit their production. Like above, they produce to MR=MC; however, the marginal cost is higher due to the tax. This means that firms' production quantities will not be too costly at higher quantity levels, so they will have to reduce the quantity to match the increased cost. A tax like this will shift supply to the left, resulting in lower quantity supplied and higher prices.

Tax and Subsidy Effect on Demand

It doesn't need to be said that consumption is taxed, as anyone who bought anything already knows. It may not seem like it, but demand often receives subsidies in various forms from the government, whether it's unemployment benefits or tax breaks for energy efficiency. Government interventions can affect demand even when imposed on producers, as changing the supply curve alters the equilibrium point with demand.

A subsidy can affect demand in multiple ways, usually for the better in the short run. A subsidy can make goods cheaper or more available, whether the subsidy is given to consumers or producers. A subsidy to consumers, such as the Covid-19 stimulus checks, increases disposable income, shifting the demand curve to the right. A rightward shift means an increase in quantity demanded and willingness to pay.

For as long as anyone has been alive, we've witnessed taxes affecting demand for sales, gas, or property. Any tax decreases disposable income and shifts the demand curve leftward, reducing the quantity demanded and lowering the willingness to pay higher prices.

Tax and Subsidy Graph

By graphing the effects of taxes and subsidies, we can easily observe the differences and how it interacts with supply and demand and how these policies change the market. In the graphs below, the following abbreviations and definitions are used:

• CS=Consumer Surplus: is the difference between a customer's willingness to pay and the actual price. In other words, a customer's excess value by buying at the equilibrium price.
• PS=Producer Surplus: is the difference between how much it costs producers to supply a good or service, and what they receive for a price on the market. The excess value producers get for selling up to the equilibrium price.
• DWL=Dead Weight Loss: Is the difference between the total surplus at competitive market equilibrium, and the new surplus after government intervention.

Below in figure 1 is a supply and demand graph that depicts the effects of a tax imposed on the market. A tax will reduce consumer and producer surplus in exchange for tax revenue, creating a market loss.

Fig 1. Tax effect on the market

The graph above in figure 1 shows a supply and demand curve at an equilibrium price and quantity. A tax is imposed on the market; this decreases the price received by producers (P₁) and increases consumer costs (P₂).

Both of these changes in a price reduce the quantity supplied and demanded (Q₂). Because the quantity exchanged is reduced, it lowers the total efficiency in the market; this is represented by the blue triangle (DWL). The pink rectangle represents the government's revenue from the tax.

The graph below represents how a subsidy impacts a market's supply and demand at equilibrium. A subsidy is implemented by the government, which pays producers to supply the product at a lower price.

Fig 2. Subsidy effect on the market

Figure 2 above shows a supply and demand curve and a market at equilibrium quantity (Q₁) and price (P₁). A governing body implements a subsidy that pays producers to provide a lower price; this causes producers to receive a higher price (P₃) and consumers to pay a lower price (P₂).

Because of this, both consumers and producers receive the regular market surplus and an additional surplus created from the subsidy. Because both parties receive a better price, they exchange a higher quantity.

However, this quantity is not as efficient as the free market. Not every dollar spent on the subsidy results in an increased surplus, some of the subsidy doesn't create value (DWL).

In summary, subsidies do create a large benefit. Still, some of the benefits are lost to what can be considered disinterested customers. The big benefit only creates value if the loss used to collect tax revenue is less efficient. That is what an efficiency maximization lens will consider; however, the social efficiency may be greater. Unfortunately, social efficiency is hard to quantify; maybe you'll be the economist who discovers a social efficiency theory.

To learn more about consumer and producer surplus, check out our explanation on Equilibrium and Consumer and Producer Surplus.