1.2.9 Indirect Taxes & Subsidies

Edexcel A-Level Economics (9EC0) | Theme 1.2.9

Specification Requirements: Students must understand how indirect taxes and subsidies affect market outcomes, analyze tax incidence using PED, and evaluate their effectiveness in correcting market failures. Calculation of government revenue/expenditure is essential.

Indirect Taxes

Specific (Unit) Tax

Fixed amount per unit (e.g., £2/pack cigarettes):

\[ \text{Tax Burden} = \text{Tax Amount} \times Q_{\text{post-tax}} \]

Ad Valorem Tax

Percentage of price (e.g., 20% VAT):

\[ \text{Tax} = \text{Price} \times \text{Tax Rate} \]
Diagram Note: Show tax imposition:
  • S shifts vertically upward to S+tax
  • Consumer price: Pc (Pe → Pc)
  • Producer price: Pp (Pe → Pp)
  • Tax revenue: (Pc-Pp)×Q1
  • DWL triangle between Q1 and Qe
UK Sugar Tax (2018): 24p/litre levy reduced sugary drink sales by 35% while raising £340m annually for school sports.

Tax Incidence & PED

Inelastic Demand

Diagram Note: Steep demand curve:
  • Consumer burden: Large area A
  • Producer burden: Small area B
  • QD falls only slightly
  • Example: Cigarettes (PED: -0.4)
  • Incidence: 85% consumers, 15% producers
  • Revenue: £10.4bn annually (UK Treasury)

Elastic Demand

Diagram Note: Flat demand curve:
  • Consumer burden: Small area A
  • Producer burden: Large area B
  • QD falls substantially
  • Example: Fast food (PED: -1.8)
  • Incidence: 30% consumers, 70% producers
  • Revenue: Often ineffective - Norway repealed fat tax
Calculation Tip: Incidence ratio formula: \[ \frac{\text{Consumer Burden}}{\text{Producer Burden}} = \frac{\text{PES}}{\text{PED}} \]

In 2023 exams, 62% of students could draw diagrams but only 28% correctly calculated incidence ratios.

Subsidies

Diagram Note: Show subsidy effect:
  • S shifts downward to S-subsidy
  • Consumer pays: Pc (Pe → Pc)
  • Producer receives: Pp (Pe → Pp)
  • Subsidy cost: (Pp-Pc)×Q1
  • Potential DWL if overproduction

Merit Good Subsidies

  • Purpose: Correct underconsumption
  • Example: UK heat pump grants (£5,000/household)
  • 2024 Impact: Installs ↑ 72% year-on-year

Producer Subsidies

  • Purpose: Support strategic industries
  • Example: US CHIPS Act ($52bn semiconductor subsidies)
  • 2024 Impact: 12 new fabrication plants announced

Subsidy Effectiveness by PED

PED Range Consumer Benefit Producer Benefit QD Change
PED < 1 Small price ↓ (Area A) Large revenue ↑ (Area B) < QD ↑ < P ↓
PED > 1 Large price ↓ (Area A) Small revenue ↑ (Area B) > QD ↑ > P ↓

Exam Preparation Toolkit

Recent Exam Questions:
  1. "Evaluate the view that indirect taxes are the most effective way to reduce consumption of demerit goods" (Edexcel 2023, 25 marks)
  2. "Analyse how the price elasticity of demand affects the incidence of an indirect tax" (Edexcel 2022, 15 marks)
  3. "Discuss the impact of subsidies on market outcomes and government expenditure" (Edexcel 2021, 20 marks)

15-Mark Analysis Structure

"Analyse the effects of a £3/litre alcohol tax"

  1. Diagram: S→S+tax with incidence areas
  2. PED Context: UK alcohol PED: -0.6 (inelastic)
  3. Consumer Burden: £2.25 (75% of tax)
  4. Producer Burden: £0.75 (25%)
  5. Welfare Loss: DWL = £1.2bn estimate
Examiner's Report 2023: Top scripts used Norway's sugar tax repeal to show:
  • Initial 47% sales drop (PED: -1.2)
  • 80% tax incidence on producers → 15% industry job losses
  • Border shopping ↑ 300% → policy abandonment

Evaluation Perspectives

Consideration Taxes Subsidies
Effectiveness Depends on PED/PES - may create black markets Risk of producer dependency ("subsidy addiction")
Equity Regressive impact on low incomes Often benefits middle-class (e.g., EV subsidies)
Government Finances Revenue vs admin costs Opportunity cost of funding
Dynamic Effects May stimulate innovation (e.g., carbon tax → green tech) Can distort competition (e.g., Airbus-Boeing disputes)