Measuring Effects of Income & Excise Taxes and Income & Excise Subsidies

1 year ago

Atiqur Rahman

9 minutes

Measuring Income Effects of Income and Excise Taxes

Choice Between Taxes

There are two types of taxes which government imposes on its citizens. One is a direct tax like the income tax, and the other is an indirect tax like the excise duty.

It has been argued that direct taxes are always better and preferable than indirect taxes because income tax puts a lower burden on the taxpayer than the indirect tax of an equal amount, i.e. the negative welfare effect of direct tax is lower than that of indirect tax. The relative burden of income and indirect tax is shown in the following diagram with the help of IC.

Let us suppose that the consumer has OM money income which he spends for buying commodity X. Given the price of X, and his budget line is MT. Now in the absence of any tax, the consumer would be in equilibrium at point E₃ on indifference curve IC_3, as shown in Fig 1 below.

Now suppose the government imposes excise duty on X, due to which the price of X will rise so that his budget line MT shifts to MR. As a result, the consumer’s equilibrium will shift to E₁ on a lower indifference curve IC₁. At equilibrium E₁, the consumer buys OQ units of X and pays MP=JE₁ for it. In the absence of the excise tax, OQ (=NK) units of X could have been purchased only for JK (=MN) of the consumer’s income. It means that the excess payment that equals JE₁−JK=KE₁ is the excise tax.

Now, let’s replace the excise tax with income tax so that the same amount of revenue (i.e., KE₁) can be collected through the income tax. This can be shown by drawing an imaginary budget line NS passing through the equilibrium point E₁, which is also parallel to the original budget line MT. Since budget line NS is parallel to the initial budget line MT, therefore income tax MN equals excise tax KE₁.

Now the budget line NS indicates that the consumer pays income tax which is equal to the excise duty, but he moves on to an upper indifference curve IC₂ where his equilibrium point becomes E₂.

Thus, an equal amount of income tax brings the consumer on a higher indifference curve than the excise tax because an excise tax, which changes the price structure, imposes both income and substitution effects on the consumer’s choice, whereas income tax imposes only income effect.

Therefore, an excise tax reduces consumer satisfaction or welfare due to both income and substitution effects, whereas an income tax reduces it only to the extent of the income effect.

Thus, it clearly indicates that the income tax is better from the consumers’ point of view, where the government gets an equal amount of revenue in both cases.

Measuring Effects of Excise and Income Subsidies

Let us suppose that the government is planning to raise the standard of living of poor people by providing them with a subsidy.

Now the subsidy could be given in two ways. First in the form of an income subsidy, which comprises of lump sum money grant, and the Second is the excise subsidy provided in the form of a food subsidy, rent subsidy or loan subsidy.

Now the main task is to evaluate which one would cost less to the government and which subsidy is preferable by the consumers?

For this, let us take a case of the choice between the income subsidy and excise subsidy on commodity X.

In the following Fig 2, the x-axis evaluates the quantity of X, and the y-axis indicates the income. In the absence of any subsidy, the consumer’s budget line is MN₁, and he is initially at E₁ equilibrium point where his IC is tangent on his budget line, and thus he consumes OX₁ units of X for which he pays MP of his income and retains OP for other goods.

Now if the government reduces the price of X by half, i.e. 50%, then the budget line will move to MN_3, and the consumer equilibrium will be at E_3, where he consumes OX₃ units of X for which he pays DM of his income.

However, if this subsidy would not be given to him, then he would have paid MB of his income for the purchase of the same quantity of X, i.e. OX₃. Hence, DB (MB – MD) is the cost of the subsidy which the government pays to the consumer for commodity X.

However, if the government had provided the income subsidy to the consumers instead of the excise subsidy, then the effect would have been different for both the consumer and the government.

For this suppose, the government supplements the consumer’s income by an amount that makes the consumer move from IC₁ to his indifference curve IC₂ which he had reached after subsidization of commodity X. This effect can be shown by drawing a budget line TN₂, which is parallel to MN₁. The consumer reaches his equilibrium at point E₂ on this new budget line and consumes OX₂ units of X for which he pays TS of his income, of which TM is the subsidy provided by the government.

If we now compare the cost of the two subsidies to the government, then we have already seen through the above diagram that the cost of excise subsidy is DB, and that of income subsidy is TM, where DB=E₃K and TM=JK.

Moreover, E₃K>JK; therefore, the government’s cost of providing excise subsidy is more than the cost of providing income subsidy. However, both policy measures lead to an increase in the consumer’s level of satisfaction as, in both cases, the consumer moves to a higher IC.

Thus, income subsidy is more efficient and always preferable than excise subsidies. But if we look at this analysis from a different angle, then we find out that it depends upon the objective of the government to implement which policy.

As in, if the policy objective is to encourage the consumption of a commodity, then an excise subsidy is preferable because an income subsidy may reduce the consumption of food. As has been seen in the above diagram that income subsidy reduces the consumption of X from OX₃ to OX₂, or it increases food consumption only marginally from OX₁ to OX₂.

On the other hand, income subsidy would encourage people to actually increase their standard of living as now they can consume less or the same amount of food and can spend their money income (provided by the government in the form of income grant or income subsidy) on other goods and services like on education, home, clothes etc.

Measuring Effects of Income & Excise Taxes and Income & Excise Subsidies

Measuring Income Effects of Income and Excise Taxes

Choice Between Taxes

Measuring Effects of Excise and Income Subsidies

Read More- Microeconomics

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Measuring Income Effects of Income and Excise Taxes

Choice Between Taxes

Measuring Effects of Excise and Income Subsidies

Read More- Microeconomics

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