Taxes, Subsidies, and Tariffs: “Small” Country

1. Taxes, Subsidies, and Tariffs: “Small” Country Udayan Roy http://myweb.liu.edu/~uroy/eco41

2. The Effects of a Tariff • A tariff is a tax on imported goods • Tariffs raise the price of imported goods above the world price by the amount of the tariff. • This • Reduces consumption, … • Increases production, and thereby … • Reduces the amount imported

3. Domestic supply Equilibrium without trade Price after tariff Price World before tariff price Imports Domestic with tariff demand S S D D Q Q Q Q Imports under free trade Effects of a Tariff on Prices and Quantities Price of Steel Tariff Quantity 0 of Steel

4. Consumer surplus before tariff Domestic supply Producer surplus before tariff Equilibrium without trade Price World before tariff price Domestic demand S D Q Q Imports under free trade Welfare under free trade Price of Steel Quantity 0 of Steel

5. Consumer surplus after tariff Domestic supply A Equilibrium without trade B Price after tariff Price World before tariff price Imports Domestic with tariff demand S S D D Q Q Q Q Imports under free trade Consumer Surplus after Tariff Price of Steel Tariff Quantity 0 of Steel

6. Domestic supply Producer surplus after tariff Equilibrium without trade Price after tariff C Price World G before tariff price Imports Domestic after tariff demand S S D D Q Q Q Q Imports under free trade Producer Surplus after Tariff Price of Steel Tariff Quantity 0 of Steel

7. Domestic supply Tariff Revenue Price after tariff E Price before tariff Imports Domestic after tariff demand S S D D Q Q Q Q Imports under free trade Government’s Revenue from Tariff Price of Steel Tariff World price Quantity 0 of Steel

8. Domestic supply A Deadweight Loss B Price with tariff C D E F Price G without tariff Imports Domestic after tariff demand S S D D Q Q Q Q Imports without tariff Effects of Tariff on Social Welfare Price of Steel Tariff World price Quantity 0 of Steel

9. Welfare Effects of a Tariff • Consumers of the imported good are worse off (compared to free trade) • Producers of the imported good are better off • The government gains some revenue • Total surplus decreases, because the loss to consumers is larger than the gains to the producers and to the government • The decrease in total surplus is called the deadweightloss of the tariff.

10. Tariffs are “third best” • The tariff can be thought of as the combination of a production subsidy and a consumption tax • The only rationale for a tariff is that it helps producers • But even that goal can be better achieved by using only a production subsidy • That way, the bad effects of the consumption tax can be avoided

11. Consumption tax

12. Domestic supply S = Q Equilibrium without trade Purchase price after tax World price Imports Domestic after tax demand S D D Q Q Q Imports under free trade Consumption Tax Price of Steel Consumption Tax Purchase price before tax Quantity 0 of Steel

13. Domestic supply S = Q Deadweight loss of the consumption tax A Equilibrium without trade B Purchase price after tax C D E F World G price Imports Domestic after tax demand S D D Q Q Q Imports under free trade Consumption Tax Price of Steel Consumption Tax Purchase price before tax Quantity 0 of Steel

14. Consumption Tax

15. Consumption Tax • When a small country imposes a consumption tax on the imported good • Production is unchanged, and • Consumption decreases. Therefore, • The amount imported decreases. • Consumers lose • Producers are unaffected • The government gains some tax revenue • The country as a whole is worse off

16. Production subsidy

17. Domestic supply D Q World Price Imports Domestic after subsidy demand = S S D Q Q Q Imports under free trade Production Subsidy Price of Steel Price sellers get after subsidy Production Subsidy Price sellers get before subsidy price buyers pay, with or without the subsidy Quantity 0 of Steel

18. Deadweight Loss Domestic supply D Q A B Price For sellers C D E F Price G For buyers Imports Domestic with subsidy demand = S S D Q Q Q Imports under free trade Production Subsidy Price of Steel Production Subsidy World price Quantity 0 of Steel

19. Production Subsidy

20. Production Subsidy • When a small country gives a subsidy to domestic producers of an imported good • Consumers are unaffected • Producers gain (C), same as under the tariff • Taxpayers have to pay for the subsidy (CD) • Overall, the country is worse off (D). • Recall that under the tariff, the country suffered even more (DF) • Tariffs are “third best”

21. Tariff = Consumption Tax + Production Subsidy

22. Tariffs are a “third-best” policy

23. Domestic supply Equilibrium without trade Price with tariff Price World without tariff price Imports Domestic with tariff demand S S D D Q Q Q Q Imports without tariff Q: What if a tariff is replaced by a production subsidy and a consumption tax, both equal in size to the tariff? A: The outcome would be identical to the outcome under the tariff. Price of Steel Tariff Quantity 0 of Steel

24. Tariffs are “third best” • The tariff can be thought of as the combination of a production subsidy and a consumption tax • The only rationale for a tariff is that it helps producers • But even that goal can be better achieved by using only a production subsidy • That way, the bad effects of the consumption tax can be avoided

25. Tariffs are “third best” • We can also establish the superiority of the production subsidy over the tariff by a head-to-head comparison

26. Q: What if the tariff shown earlier were replaced by a production subsidy equal in size to the tariff? Domestic supply D Q A B Price For sellers C D E F Price G For buyers Imports Domestic with subsidy demand = S S D Q Q Q Imports under free trade Price of Steel A: Producers would not complain. Consumerswould be delighted. Taxpayers would complain. The country as a whole would be better off. Production Subsidy World price Quantity 0 of Steel

27. Domestic supply A B Price after intervention C D E F Free Trade Price G Domestic demand S S D D Q Q Q Q Imports under free trade Price of Steel government intervention World price Quantity 0 of Steel

28. In its welfare effects, not all that different from the tariff The Import quota

29. The Effects of an Import Quota • An import quota is a limit—imposed by the domestic government—on the quantity of a good that can be produced abroad and sold domestically.

30. Domestic supply Equilibrium without trade Domestic supply + Import supply Isolandian price with Equilibrium quota with quota Price World World without = price price Imports quota Domestic with quota demand S S D D Q Q Q Q Imports without quota The Effects of an Import Quota Price of Steel Quota Quantity 0 of Steel

31. The Effects of an Import Quota • Because the quota raises the domestic price above the world price, • domestic buyers of the good are worse off, and • domestic sellers of the good are better off. • Import license holders are better off • they make a profit from buying at the world price and selling at the higher domestic price.

32. Domestic supply Equilibrium without trade Domestic supply A + Import supply Isolandian B price with Equilibrium quota with quota E' C D F Price World World without = G price price Imports quota Domestic with quota demand S S D D Q Q Q Q Imports without quota The Effects of an Import Quota Price of Steel Quota E" Quantity 0 of Steel

33. The Effects of an Import Quota

34. The Effects of an Import Quota • With a quota, total surplus in the market decreases by an amount referred to as a deadweight loss. • The quota can potentially cause an even larger deadweight loss, if a political mechanism such as lobbying is employed to allocate the import licenses.

35. Tariffs v. Quotas • If government sells import licenses for full value, • the revenue would equal that from an equivalent tariff and • tariffs and quotas would have identical results. • Otherwise, quotas are worse than tariffs

36. The Lessons for Trade Policy • Both tariffs and import quotas . . . • raise domestic prices. • reduce the welfare of domestic consumers. • increase the welfare of domestic producers. • cause deadweight losses.