Taxes & Subsidies
A tax is a vertical wedge between what buyers pay and what sellers keep. Legal incidence does not determine economic incidence — and the inelastic side bears the tax.
The wedge
Two ways to draw it, one answer
| Collected from | Curve that moves | Why |
|---|---|---|
| Producers | Supply shifts up by the tax | Extra marginal cost |
| Consumers | Demand shifts down by the tax | Reduced marginal benefit |
Both give the same equilibrium — same quantity, same price paid, same price kept. Only the drawing differs.
Who actually bears it
- Inelastic demand
- Consumers bear more. Price rises nearly the full tax, quantity barely moves, deadweight loss is small.
- Inelastic supply
- Producers bear more. More elastic on either side ⇒ bigger fall in quantity ⇒ bigger deadweight loss.
- Evidence
- Europe's far higher gas taxes show up in correspondingly higher pump prices, so consumers bear them: gasoline supply is far more elastic than demand.
- Corollary
- Taxing inelastic goods is more efficient — cigarettes — because less quantity is distorted. Efficiency, not fairness.
Where the competitive model breaks
Benzarti et al. (2020): Finnish hairdressers got a 14-point VAT cut in 2007, repealed in 2012, with beauty salons as control. Cuts are only about 50% passed through to consumers; increases pass through almost fully. Consumers are inattentive to taxes, so firms pocket part of a cut and can blame the tax for an increase. Edwards: price determination does not work like the basic competitive model, and we should not take its predictions as gospel.
Subsidies
A subsidy is a negative tax and it overshoots. Quantity rises past the efficient Q₁, so on every extra unit MB < MC. Consumers pay PC, producers receive PC + subsidy, and the government's rectangle exceeds the combined gain in consumer and producer surplus. The difference is the triangle.
Rules that earn points
- Draw the no-tax equilibrium, then a wedge of height = tax between the curves.
- Mark three prices: what buyers pay, what sellers keep, the original in between.
- Revenue = the rectangle tax × Q₂. Deadweight loss = the triangle to its right.
- For incidence, name the more inelastic side; it bears more.
- Claiming the side that legally pays the tax bears it. Both diagrams give the same answer.
- Assuming the price rises by the full tax. It rises by less, unless demand is perfectly inelastic.
- Saying subsidies have no efficiency cost. They overproduce, and that is a real triangle.
- Confusing revenue with deadweight loss. Revenue is a transfer; only the triangle is destroyed.
A $1 per-unit tax is switched from being collected from sellers to being collected from buyers. Compared with the old equilibrium, the new one has:
- AThe same quantity, the same price paid by buyers, the same price kept by sellers
- BA lower price paid by buyers, because they now write the check
- CA higher quantity, because supply no longer shifts
- DThe same quantity, but buyers now bear the whole tax
Answer
A — everything real is unchanged.
Collected from producers the tax shifts supply up by $1; collected from consumers it shifts demand down by $1. Both land on the same quantity and the same pair of prices. Legal incidence does not determine economic incidence.
D is the trap: it gets the quantity right but assumes whoever remits the tax bears it. Incidence is set by elasticities, not by the statute.
Demand for a good is perfectly inelastic. A $2 per-unit tax is imposed. The price consumers pay and the deadweight loss are:
- ARises by less than $2; deadweight loss is positive
- BRises by $2; deadweight loss is zero
- CRises by $1, split evenly; deadweight loss is positive
- DUnchanged; producers bear the entire tax
Answer
B — the price rises the full $2 and there is no deadweight loss.
The completely inelastic side bears the whole tax, and because quantity does not move, no trades are destroyed. Deadweight loss comes from distorted quantity, not from the tax itself.
A is the trap: "the price rises by less than the tax" is the normal case, not a law. It fails exactly when one side is perfectly inelastic.
Which best describes the efficiency case for taxing cigarettes?
- ADemand is inelastic, so quantity barely moves and the deadweight loss triangle stays small
- BDemand is elastic, so the tax discourages a lot of smoking
- CThe tax is fair, because smokers can afford it
- DThe tax raises revenue, and revenue is a gain to society
Answer
A — inelastic demand means little quantity distortion.
Large revenue, small triangle. This is purely an efficiency argument; taxes on inelastic necessities tend to be regressive, so it says nothing about fairness.
D is the trap: revenue is a transfer from buyers and sellers to government, not a social gain. Only the triangle is destroyed.
Benzarti and coauthors (2020) found that in the Finnish hairdresser VAT episode, pass-through to consumers was:
- AAbout 50% for the cut and nearly 100% for the increase
- BNearly 100% for the cut and about 50% for the increase
- CAbout 50% in both directions, as the competitive model predicts
- DNearly 100% in both directions, confirming the competitive model
Answer
A — asymmetric: cuts stick to firms, increases reach consumers.
The 14-point cut in 2007 was repealed in 2012, with beauty salons as the control group. Consumers are inattentive to taxes, so firms pocket half a cut but can justify a visible price rise by pointing at the tax.
C and D are the traps: both assume symmetry. The whole point of the paper is that price determination does not work like the basic competitive model.
Draw the effect of a 50¢ per gallon gasoline tax collected from producers. Then draw the same tax collected from consumers instead. Compare the two outcomes.
Model answer
From producers: supply shifts up by 50¢, since the tax is an extra marginal cost. New quantity Q₂, consumers pay P₂, producers keep P₂ − 0.50.
From consumers: demand shifts down by 50¢, since the tax is a negative marginal benefit. New quantity Q₂, producers receive P₂, consumers pay P₂ + 0.50.
Identical in substance: same quantity traded, same price paid by consumers, same price kept by producers. Only the drawing differs — legal incidence is irrelevant to economic incidence.
- Shifting the correct curve in each case, and by exactly 50¢ vertically.
- Naming the reason for each shift: extra marginal cost, reduced marginal benefit.
- Marking all three prices, not just one.
- Stating explicitly that quantity and both prices are the same in both diagrams.
- Labelling the revenue rectangle and the deadweight loss triangle.
A subsidy makes consumers pay less and producers receive more. Explain why it still creates deadweight loss, and show it on a diagram.
Model answer
The subsidy drives a wedge the opposite way from a tax: quantity rises to Q₂ > Q₁, consumers pay PC below P₁, producers receive PC + subsidy above P₁.
Consumer and producer surplus both rise, but the government pays a rectangle bigger than their combined gain. The excess is the deadweight loss triangle, sitting to the right of Q₁ between supply and demand.
The intuition: on every unit past Q₁, MB < MC. Society spends more to make those units than anyone values them at, and taxpayers fund the gap.
- Q₂ drawn to the right of Q₁ — overproduction, not underproduction.
- Saying MB < MC on the extra units. That one inequality is the whole answer.
- Comparing the government's rectangle to the combined surplus gain, not just asserting a loss.
- The triangle located to the right of Q₁, between supply and demand.