Government Intervention: Taxation & Subsides (Edexcel IGCSE Economics)
Government Intervention To Deal With Externalities
Spec point —
1.1.5f
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To correct externalities, a government can use taxation or subsidies to influence the level of consumption or production of a good or service
- Indirect taxes increase the cost of production which is then passed on as an increase in price. Taxes are useful to address externalities where goods are over-provided
- Subsidies lower production costs and therefore increase output of the product. Subsidies are useful to address externalities where goods are under-provided or under-consumed
Taxation
Spec point —
2.1.1e
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Indirect taxes are levied by the government on producers, increasing the cost of production for firms
- Higher prices may reduce the quantity demanded (QD) and discourage the consumption of specific goods or services that generate negative externalities
Example
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A sugar tax was levied on sugary drinks in the UK (2018)
- The aim was to reduce consumption of sugary drinks
- The consequence of poor health and obesity caused by excess sugar intake are paid for by third parties,
- In this case, the third party is the taxpayer, who funds the healthcare provided by the UK National Health Service
Evaluating the use of indirect taxes to reduce negative externalities
| Stakeholder | Advantages | Disadvantages |
|---|---|---|
| Consumers | - Reduced consumption of goods with external costs, leading to lower costs to third parties - E.g. Cigarette tax (excise duty) leads to higher priced cigarettes, which reduce s consumption and therefore less passive smoking for third parties | - "Sin Taxes" often affect low-income consumers disproportionately, worsening inequality - The effectiveness of the tax depends on the price elasticity of demand (PED) - Many consumers who purchase products that are price inelastic in demand such as cigarettes and alcohol will **continue to do so, **not reducing consumption |
| Producers | - Producers are forced to pay for external costs associated with emissions from production of harmful goods - E.g. Air pollution is fined, increasing the cost of production and therefore** internalising the externality** | - Producers may be forced to make some workers redundant as output falls due to the higher costs of production - This is particularly the case if the producer cannot pass on the higher costs as higher prices |
| Government | - Raises revenue for government programs - Could be used to fund healthcare and education initiatives about the consumption of goods with external costs | - It may create illegal markets as consumers seek to avoid paying the taxes |
Subsidies
Spec point —
2.2.2c
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Subsidies attempt to increase the output and consumption of specific goods or services that have external benefits
- A subsidy is a payment to a firm that reduces the costs of production and encourages an increase in the output of a good or service
Example
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The UK government provides subsidies to firms producing renewable energy equipment
- The subsidy lowers the cost of production of air source heat pumps and loft insulation
- Consumers demand more of of these energy saving devices at a lower price, therefore using less fossil fuel to heat their homes
- This reduces the negative externality associated with the use of fossil fuels
Evaluating the use of subsidies to promote products with positive externalities
| Stakeholder | Advantages | Disadvantages |
|---|---|---|
| Consumers | - Lowers prices and increases demand for goods with positive externalities - It helps to change destructive consumer behaviour over a longer period of time, e.g. subsidising electric cars makes them affordable and increases demand | - Subsidies may disproportionately benefit higher income consumers, e.g. on electric vehicles |
| Producers | - Can be targeted so as to help specific domestic industries | - Subsidies can discourage firms from becoming more efficient or competitive, as they become reliant on financial assistance from governments |
| Government | - It helps achieve environmental aims - It helps reduce carbon emissions and improve air quality | - There is an opportunity cost associated with government expenditure; could the money have been better used elsewhere? |
Exam Hint In Paper 1, you may be given a scenario and asked to assess the impact of the taxation or subsidy. Make sure you have a balanced argument and consider how effectively the intervention impacts the consumption or production of that good/service (e.g. subsidy may increase consumption of positive externality goods but also have an opportunity cost)
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