Analysis of Electricity Price Subsidies and Income Taxes in Australia

Electricity Price Subsidies

1. Electricity price subsidies

In many countries, the residential price of electricity is subsidized but often you can hear that such a subsidy is “inefficient.” In this exercise, you will show why. Throughout your analysis, assume that an average consumer in the imaginary country of Fantasia has 2,000 Fantasian dollars a month to spend on electricity and all other consumption; the market (unsubsidized) price of electricity is 25 Fantasian cents per kWh, and the government gives a 20% subsidy on each kWh per consumption for everyone under an income threshold of 5,000 Fantasian dollars.

(a) (6 points) In a graph with kWh of electricity on the horizontal axis and all other consumption (measured in Fantasian dollars) on the vertical, draw the budget constraints of the average Fantasian consumer with and without the subsidy. Remember to label the intercepts and slopes.

(b) (6 points) With the subsidy in place, the average Fantasian consumer consumes 150 kWh electricity a month. Mark this on your graph. How much do they have left for all other consumption? How much do they cost to the government? Illustrate the government’s cost in your graph.

(c) (6 points) The shadow minister of the economy in Fantasia criticizes the government by saying: “The average consumer would be better off if the government just handed over the amount the subsidy costs in cash to them. Therefore, the electricity subsidy is inefficient.” Is the shadow minister right? Explain.

(d) (6 points) What the shadow minister is proposing in part (c) is called a lump-sum subsidy. The average consumer responds, “I don’t really care if the government switches to the shadow minister’s proposal – it does not really affect me.” Why do you think they say that? (Hint: What do you think their indifference curves look like?)

(e) (6 points) In light of your answer to part (c), why would it be difficult for the government to implement the lump-sum subsidy instead of the proportional one? (Hint: Think about what information the government needs to be able to switch.)

2. Income taxes in Australia

This question asks you to think about features of the current Australian personal income tax system.

 

(a) (5 points) Go to the web page https://www.ato.gov.au/rates/individual-income-taxrates/, and based on the information on 2021-22 individual income tax rates for residents,
calculate the marginal tax rates for each category of taxable income. I.e., fill out the following table:

(b) (5 points) Assume Australian people have 3,000 hours per year to allocate between work and leisure. Look up the national hourly minimum wage in Australia effective from 1st July2021, and using the marginal tax rates from part (a), draw the budget constraint of Jamie, a bartender in Canberra, who earns minimum wage. Remember to label the intercepts and slope(s) of the budget constraints.

(c) (5 points) Assume Jamie works part time and makes exactly $18,200. How much tax does he/she pay? Jamie is considering taking up some more hours to get hold of some extracash. Assuming Jamie would still earn minimal wage, what’s his/her take-home hourly wage on those extra hours? Where can you see this graphically? Show in your graph the tax Jamie pays if he/she decides to work 100 more hours over the course of the year.

(d) (5 points) Despite Jamie decides to work 100 more hours a year, he/she complains, “Income tax really discourages me to work.” What does he/she mean? Explain. (Hint: Think about how many hours Jamie would have chosen to work with no taxes at all.)

(e) (5 points) Is this tax schedule progressive? Explain.

(f) (5 points) Can you mention one argument for creating progressive tax systems? Do you agree with this argument? Why or why not?