Chapter 27: Government in the Marketplace — Taxes and Subsidies

Book: Economics 101

Author: Alfred Mill & Michele Cagan

Type: Chapter

Category: Economics

Difficulty: Beginner

Reading time: 9 min

Core idea

Government has two tools for nudging markets without directly setting prices: taxes make a transaction more expensive (shrinking supply or demand), subsidies make it cheaper (expanding them). Both work by shifting the curves rather than by fixing the price — which usually causes less distortion than the price controls from chapter 26. Taxes are used to raise revenue, discourage harmful behavior (sin taxes on alcohol and tobacco), and redistribute income. Subsidies are used to encourage industries the government wants more of (agriculture, R&D, clean energy), support struggling sectors (COVID PPP loans), or help low-income households (food assistance). Both come with consequences: taxes can drive activity into black markets; subsidies can entrench inefficient producers and crowd out competitors abroad.

Authors’ framing: Government uses taxes and subsidies not only to raise revenue but to shape people’s incentives. Done thoughtfully, that’s powerful. Done carelessly, it produces black markets, deadweight losses, and welfare programs that fail the people they were meant to help.

Why it matters

Almost every major policy debate — climate, healthcare, housing, technology, agriculture, defense — eventually becomes a debate about which taxes to raise and which subsidies to grant. Understanding how the tools work is the difference between informed debate and slogans.

Taxes as behavior policy, not just revenue

When the government raises the cigarette tax, it isn’t only after the money. It’s deliberately making smoking more expensive to discourage it. The cigarette tax is unusual among taxes in that its success means less revenue — if fewer people smoke, less tax is collected. The same logic applies to carbon taxes (success = less burning of fossil fuels = less revenue) and to alcohol taxes. These are sometimes called Pigovian taxes after the economist who first formalized them — they internalize negative externalities into the price.

Subsidies as industrial policy

The US doesn’t have a formal “industrial policy” the way many European and Asian governments do. It has subsidies — agricultural payments, research tax credits, accelerated depreciation, mortgage interest deduction, electric-vehicle incentives. These add up to a de facto industrial policy that favors farmers, homeowners, R&D-heavy firms, and (increasingly) clean energy. Whether that mix is the right one is a political question; the mechanism is the same in every case: lower the producer’s cost or raise the consumer’s willingness to pay, watch the market produce more.

Why the form of the support matters

Two subsidies of identical dollar value can have wildly different effects. Cash transfers let the recipient choose what to buy. Earmarked subsidies (food stamps, housing vouchers) let them buy only specific things. Cash is almost always more efficient — the recipient has better information about their own needs — but earmarked aid is more politically palatable because voters prefer to believe their dollars buy food rather than “whatever the family decides they need.” When the gap between need and authorized use is large enough, a black market appears to bridge it.

Key takeaways

Key takeaways

• Taxes raise the cost of production (shift supply leftward) or the price to consumers, reducing the quantity traded. Used for revenue, behavioral nudging, and redistribution.
• Subsidies lower the cost of production (shift supply rightward) or augment consumer income, increasing the quantity traded. Used to encourage favored industries and support vulnerable groups.
• Sin taxes (alcohol, tobacco, sugar) target consumption of goods with externalities. Success reduces both consumption AND tax revenue — a feature, not a bug.
• Pigovian taxes internalize negative externalities. Subsidies for positive externalities (vaccines, education) do the inverse.
• Tax cuts can be supply-side policy: lowering corporate or capital-gains taxes is intended to spur investment. Empirical results are mixed; the 2017 TCJA boosted investment modestly but added over $1T to the deficit.
• Agricultural subsidies illustrate the dark side: they entrench producers, create export pressure that hurts poor-country farmers, and persist far past any original justification.
• Black markets emerge whenever taxes or subsidies create a wedge between authorized use and actual need — food stamps trade at roughly 50¢ on the dollar in some markets.
• Cash transfers are usually more efficient than in-kind transfers, but earmarked aid is more politically defensible.

Mental model — how taxes and subsidies shift markets

click to zoom

Two tools, mirror-image effects on quantity and price.

Read it as: Taxes and subsidies are mirror tools. A tax (red branch) raises costs, shifts supply left, raises price, and reduces quantity. A subsidy (green branch) lowers costs, shifts supply right, lowers price, and increases quantity. Each has a characteristic failure mode (purple): taxes invite evasion via black markets; subsidies entrench inefficient producers who’d lose in a competitive market.

Mental model — tax incidence (who actually pays?)

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The legal payer of a tax is rarely the economic bearer.

How to read this diagram

A tax’s legal target (“who writes the check”) is decided by lawmakers; its economic incidence (“who actually loses purchasing power”) is decided by elasticity. When buyers have no alternatives (gasoline, prescription drugs, addictive products), they bear most of the tax even when it’s nominally on the producer. When buyers can easily walk away, the producer eats it. The right way to evaluate a tax is to ask what its incidence is, not what its statutory target is.

Practical application

Design a tax for the behavior you actually want

Three rules for behavior-shaping taxes

1. Target the externality, not the product. A carbon tax is better than a “fossil fuel use tax” because it scales with the actual harm. A tax on sugar in soda is better than a tax on soda volume.
2. Set the rate high enough to matter. A $0.05 cigarette tax doesn’t change behavior. A $5 one does. If the policy goal is behavioral change, the rate has to bite.
3. Watch the substitutes. Tax sugary soda and people switch to artificially sweetened soda or sweetened coffee drinks; tax cigarettes and people switch to vaping. If you don’t tax the substitutes proportionally, behavior shifts but health outcomes don’t.

Choose between cash and in-kind transfers

1. Default to cash. It’s cheaper to administer, gives recipients agency, and avoids creating black markets. Earned Income Tax Credit (EITC) is a US example that mostly works.

2. Use vouchers when the worry is misuse. Housing vouchers, school vouchers, and food stamps exist because voters demand that the aid be spent on the named purpose. The cost is some efficiency loss and some black-market trading.

3. Use direct provision (government runs it) when the market would underprovide. Public schools, public health, basic research — goods that produce large positive externalities and where private provision is incomplete.

4. Match the subsidy form to the elasticity. For elastic activities (you respond strongly to price), small subsidies work. For inelastic activities (heating in winter, insulin), you need either direct provision or much larger subsidies to actually shift behavior.

Example: three subsidy designs for the same goal

Imagine the government wants to ensure low-income families can afford healthy food. Three policy designs, same nominal goal:

Design A: Cash transfer. Send $300/month to qualifying families, no strings. Maximum flexibility. Recipients choose between groceries, diapers, transportation, medicine, utilities. Total administrative cost: ~3%. Risk: some recipients spend on non-essentials.

Design B: Food stamps (SNAP). $300/month in vouchers redeemable only for food. Recipients can’t divert to rent or diapers. Administrative cost: ~5%. Black market emerges: some recipients trade $100 in food stamps for $50 cash to buy non-food essentials, leaving them with neither full food nor full essentials.

Design C: Direct food provision. Government buys bulk food and distributes via food pantries. No discretion for recipients. Administrative cost: ~12%. Recipients receive what’s on the truck, not what they need. Significant unmet demand for fresh produce, dietary-restricted food, culturally appropriate items.

If the policy goal is “improve nutrition and reduce hardship,” the economics strongly favors A (cash) > B (vouchers) > C (direct provision). If the policy goal is “ensure the money is spent on food, visibly,” voters often favor the reverse order. The same $300 produces dramatically different outcomes depending on the form.

The economist’s contribution is to make the trade-off visible. The political choice — which form to pick — depends on whose welfare you weight more: the recipient (who benefits from flexibility) or the voter (who wants visible spending discipline). There is no economically neutral answer.

Caveats

Caution

Subsidies are sticky in ways taxes aren’t. A subsidy creates a constituency that fights to keep it — agricultural subsidies have outlived every original justification, partly because the recipients are concentrated and organized while the cost is spread thinly across all taxpayers. The “temporary” subsidy is a near-extinct species.

Taxes have deadweight loss. Even well-designed taxes shrink the size of the market — some trades that would have created value don’t happen. The deadweight loss isn’t a side effect; it’s how the tax achieves its behavioral goal. Whether the goal is worth the loss is a values question, not an economic one.

Empirical reality often disappoints theory. Supply-side tax cuts (e.g. TCJA 2017) often produce smaller effects on hiring and wages than promised, and large effects on the deficit. Subsidies (e.g. solar, EVs) sometimes accelerate adoption dramatically and sometimes just enrich existing buyers. Always check the realized effect against the predicted one.

Related lessons

Related

Chapter 26: Price Ceilings and Price Floors Government's blunter market levers — and why taxes/subsidies usually distort less than direct price controls. Chapter 28: Market Failures Externalities and public goods — the failures that Pigovian taxes and subsidies were invented to correct. Concept: Fiscal policy Taxes and subsidies at the macro level — how the federal budget shapes aggregate demand and the business cycle. Concept: Supply and demand The curves that taxes and subsidies shift — the mechanism that makes both tools work.