7.2 Taxes and Subsidies
In addition to direct price regulation, the State can intervene in the market through fiscal instruments—taxes and subsidies—with the aim of correcting market failures (such as externalities, which we will discuss in Chapter 8) or promoting redistributive objectives. This section explores the effects of these instruments on the equilibrium price, the quantity exchanged, and overall social welfare.
Effects of a Per-Unit Tax
Per-unit taxes, or excise taxes, are levied on each unit A lump-sum tax (or subsidy), such as one imposed on consumers, has a fixed amount and thus represents a pure reduction (or increase) in income, as discussed for example in Section 2.4 when talking about compensating and equivalent variation. of a good traded, regardless of its sale price—unlike ad valorem taxes, which are charged as a percentage of the good’s value. This type of intervention alters the incentives faced by both consumers and producers, reducing the quantity traded and creating a wedge—called a tax wedge—between the price paid by consumers and the price actually received by producers. In a competitive market, the introduction of a tax results in a deadweight loss.
To analyze its effects, let us assume the tax is levied on producers: for each unit sold, each firm must pay the State an amount equal to $T$ euros. This is equivalent to an increase in marginal cost of $T$, which causes a parallel upward shift of the individual supply curve and, since the market supply is the horizontal sum of individual supplies, also of the market supply curve. And what if the tax were imposed on consumers instead? In that case, their willingness to pay would decrease by $T$ euros per unit, resulting in a parallel downward shift of the demand curve.
In both scenarios, the quantity exchanged falls, the price paid by consumers increases, and the price actually received by producers decreases. As shown in the following figure, the market effects are identical in the two cases: what matters is the economic incidence of the tax, not who formally remits it to the State.
It is interesting to observe the similarities and differences among the State interventions analyzed so far: price floor, price ceiling, and per-unit tax. As shown in the following figure, all three measures result in a reduction in the quantity traded and a corresponding decrease in total surplus. The main differences between these interventions thus concern the distribution of welfare among economic agents.
Effects of a Subsidy
A subsidy works symmetrically to a tax: instead of imposing a cost on each unit traded, the State provides a transfer—equal to $T$ euros—for each unit sold or purchased. Let us first consider the case where the subsidy is granted to producers: this is equivalent to a reduction in marginal cost of $T$, which shifts the supply curve downward. If the subsidy is instead targeted at consumers, it increases their willingness to pay, shifting the demand curve upward by $T$. In both cases, the market effects are identical: the quantity traded increases, the price actually paid by consumers decreases, and the price received by producers increases.
The introduction of a subsidy increases the surplus of both consumers and producers, but it comes at a cost to the State, equal to the amount of the subsidy multiplied by the quantity traded. If the fiscal cost exceeds the gain in private surpluses, the intervention results in a deadweight loss. As with taxes, the final incidence of a subsidy depends on the elasticity of demand and supply, not on who formally receives the transfer.
Economic incidence of taxes and subsidies
By creating a wedge between the price paid by consumers and the price received by producers, a per-unit tax reduces the welfare of both parties, while a subsidy increases it. But who bears most of the burden of a tax, or who benefits the most from a subsidy? As we have seen, the answer does not depend on who formally pays the tax to the State or who receives the subsidy, but rather on how consumers and producers react to the price change: it is this joint response that determines the economic incidence of the intervention.
In Chapter 4, we saw that when a shock originates from the demand side (such as a change in consumer income), the new equilibrium is reached by moving along the supply curve; conversely, a supply-side shock shifts the equilibrium along the demand curve. Taxes and subsidies produce a different effect: they simultaneously alter the incentives on both sides of the market. A tax, for example, makes purchasing more expensive for consumers and selling less profitable for producers. For this reason, the adjustment to the new equilibrium occurs along both curves: demand falls due to the higher consumer price, and supply contracts due to the lower effective price received by producers.
The side of the market that reacts less to the price change tends to bear a larger share of the tax burden. If demand is relatively inelastic compared to supply, consumers bear most of the fiscal burden; if instead supply is less elastic, producers absorb most of the cost. This is easy to verify graphically. If, for example, the demand curve were perfectly inelastic (i.e., vertical), the entire amount of the tax would be passed on to consumers through a higher price, while the quantity traded would remain unchanged. In this extreme case, the entire tax burden would fall on consumers: their surplus would decrease, while the producers’ surplus would be unaffected.
The elasticities of demand and supply also determine the efficiency loss caused by the intervention. This, too, is easy to see graphically. In the case of perfectly inelastic demand, the quantity remains unchanged, and thus the deadweight loss is zero: the consumers’ lost surplus is fully converted into tax revenue. If demand is instead highly elastic, even small price changes lead to large reductions in the quantity traded, increasing the deadweight loss in terms of welfare.
Other Types of Taxes
Beyond the per-unit taxes discussed so far, there are other forms of taxation that can affect market functioning in different ways. Two particularly relevant types are ad valorem taxes and lump-sum taxes.
Ad valorem taxes are levied as a percentage of the good’s value — for example, a 20% tax on the selling price. Graphically, they do not cause a parallel shift in the demand or supply curve (as with an excise tax), but instead reduce the slope. The equilibrium effects are qualitatively similar to those of a per-unit tax — a reduction in the quantity traded, an increase in the price paid by consumers, and a decrease in the price received by producers. The size of the deadweight loss again depends on the elasticities of demand and supply.
Lump-sum taxes, by contrast, do not depend on the quantity consumed or the value of the good: they consist of a fixed amount per individual or firm. A classic example is a license fee that a firm must pay in order to operate, regardless of how much it produces or sells. These taxes do not distort marginal decisions and therefore do not generate deadweight losses in standard models. However, they do have important redistributive effects: a lump-sum tax imposed on all consumers, for instance, reduces
The price of gasoline in Italy includes both a fixed excise tax (around 70 cents per liter) and a 22% value-added tax (IVA). The IVA is applied to the total price, including the excise — a “tax on the tax”.
their disposable income and thus market demand.
Finally, it is worth noting that real-world fiscal policies often combine multiple forms of taxation. For example, a good may be subject to both an excise tax (fixed per unit) and a value-added tax (percentage of the price). The choice among different forms of taxation depends on the objectives pursued by the State: efficiency, equity, administrative simplicity, or revenue stability.