Indirect Taxes and Subsidies

Specification Coverage: Edexcel unit 1.2.9 - Indirect taxes and subsidies. Students should understand how indirect taxes and subsidies affect market outcomes, including their effects on price, quantity, government revenue or cost, and the role of price elasticity of demand in determining incidence.

Indirect Taxes

Definition: A tax levied on goods and services when they are purchased, such as VAT or sugar tax. It is paid indirectly by the consumer via the producer, so affects the supply curve rather than the demand curve.

Types of Indirect Tax:

  • Specific tax: A fixed amount of tax per unit sold, e.g. £0.50 per pack of cigarettes.
  • Ad valorem tax: A percentage of the price, e.g. 20% VAT on most goods and services.

Purpose: To raise government revenue and/or to discourage consumption of demerit goods, such as cigarettes or sugary products.

Impact on Supply: An indirect tax increases a firm's costs of production. This is shown by a leftward (upward) shift of the supply curve.

Analysing a Specific (Per-Unit) Tax

Demand and supply diagram showing an indirect tax shifting supply left, with the burden split between consumers and producers
Figure 1: The impact of a specific tax on supply, price, quantity, and tax incidence.
  • The Shift: Supply shifts left from S to S+Tax.
  • The vertical distance between S and S+Tax equals the tax per unit.

New Equilibrium

  • Consumer price rises from P1 to P2.
  • Quantity falls from Q1 to Q2.

Tax Incidence

  • Consumer incidence: (P2 - P1) x Q2. This is the portion of the tax paid by consumers via the higher price. Represented by the green area.
  • Producer incidence: (P1 - P3) x Q2. This is the portion of the tax paid by producers via lower revenue. Represented by the blue area.
  • Government revenue: Total tax x Q2 = (P2 - P3) x Q2. This is the sum of consumer and producer incidence.

Worked Example: Calculating Tax Incidence

The government places a specific tax of £2 per unit on a good. The market moves as follows:

Before the tax After the tax
Price paid by consumers P1 = £8.00 P2 = £9.50
Price received by producers £8.00 P3 = £7.50
Quantity traded Q1 = 100 Q2 = 92
Consumer incidence (£9.50 − £8.00) × 92 = £138
Producer incidence (£8.00 − £7.50) × 92 = £46
Government revenue (£9.50 − £7.50) × 92 = £184

The two incidences add to the government's revenue: £138 + £46 = £184. Every area is measured at the new quantity Q2, not the old one - using Q1 would overstate all three. Consumers here carry 75% of the tax, which tells you demand is the more inelastic side of this market.

The Role of Price Elasticity of Demand (PED)

The relative burden, or incidence, of a tax depends on the PED of the product.

Two tax diagrams showing consumers bearing more of the tax when demand is inelastic and producers more when it is elastic
Figure 2: The impact of an indirect tax when demand is price inelastic vs. price elastic.
Demand is Price Inelastic Demand is Price Elastic
  • Example: cigarettes or petrol.
  • Consumers pay most of the tax.
  • Qd falls only slightly.
  • Tax is effective at raising revenue but less effective at reducing consumption.
  • Reason: Consumers are less responsive to price changes.
  • Example: restaurant meals or branded pizza.
  • Producers pay most of the tax.
  • Qd falls significantly.
  • Tax is more effective at reducing consumption, but raises less revenue and harms producers more.
  • Reason: Consumers are highly responsive to price changes.

Subsidies

Definition: A per-unit payment from the government to producers to lower their costs of production.

Purpose: To encourage production and consumption of merit goods, such as solar panels or education, or to support key industries.

Impact on Supply: A subsidy lowers a firm's costs of production. This is shown by a rightward (outward) shift of the supply curve.

Analysing a Subsidy

Demand and supply diagram showing a subsidy shifting supply right, with the benefit split between consumers and producers
Figure 3: The impact of a subsidy on supply, price, quantity, and subsidy incidence.
  • The Shift: Supply shifts right from S to S+Subsidy.
  • The vertical distance between S and S+Subsidy equals the subsidy per unit.

New Equilibrium

  • Consumer price falls from P1 to P2.
  • Quantity rises from Q1 to Q2.

Subsidy Incidence

  • Consumer incidence: (P1 - P2) x Q2. This is the benefit to consumers from the lower price.
  • Producer incidence: (P3 - P1) x Q2. This is the benefit to producers from higher revenue per unit.
  • Government cost: Total subsidy x Q2 = (P3 - P2) x Q2. This is the total expenditure by the government.

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Ten original multiple-choice questions on specific and ad valorem taxes, tax incidence, subsidies and how price elasticity decides who really pays.

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Five questions on Indirect Taxes and Subsidies from the Edexcel A-Level papers, 2017–2021, 5 to 25 marks. Each one links straight to the page of the official mark scheme where its answer begins.

Past Paper Questions: 1.2.9 Indirect Taxes and Subsidies