Question

Suppose the output or goods market is in equilibrium and the level of taxes in that country is increased. How does this affect the output market? Explain your answer through the sequence of change(s) on any variable(s) involved.

Answer 1

Taxes reduce both demand and supply, and drive market equilibrium to a price that is higher than without the tax and a quantity that is lower than without the tax. Hence we can say with increase in tax, prices rise and quantity falls.

At a given level of demand, taxation's reduction of incentives will result in a decrease in the production of goods or services. Taxes increases the cost for the suppliers which inturn leads to reduction in quantities supplied making the supply curve shifts to left side.

If a new tax is put into place for buyers, it reduces consumer demand—because the price of goods relative to their value to consumers has gone up.

If the buyers have many alternatives to the product then with a new tax, buyers will respond to a rise in price by buying other things without accepting a much higher price. If sellers easily can switch to producing other goods, or if they will respond to even a small reduction in payments by going out of business, then they will not accept a much lower price. The incidence of the tax will tend to fall on the side of the market that has the least attractive alternatives and, therefore, has a lower elasticity.

It is important to remember, though, that taxes finance government spending, which also contributes to the position of the demand curve. When government spending increases, so does aggregate demand. In some cases, a tax may cause a decrease in demand of products consumed primarily by individual consumers and an increase in demand of products consumed primarily by firms or government.