Indirect Taxes & Subsidies (Edexcel A Level Economics A)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
Indirect Taxes
An indirect tax is paid on the consumption of goods/services
It is only paid if consumers make a purchase
It is usually levied by the government on demerit goods to reduce the quantity demanded (QD) and/or to raise government revenue
Government revenue is used to fund government provision of goods/services e.g education
Indirect taxes can occur as a specific or ad valorem tax
They are levied by the government on producers. This is why the supply curve shifts
Producers and consumers each pay a share (incidence) of the tax
The incidence of a specific tax
Diagram analysis
The government places a specific tax on a demerit good
The supply curve shifts left from S1→S2 by the amount of the tax
The price the consumer pays has increased from P1 before the tax, to P2 after the tax
The price the producer receives has decreased from P1 before the tax to P3 after the tax
The government receives tax revenue = (P2-P3) x Q2
The consumer incidence (share) of the tax is equal to area A - (P2-P1) x Q2
The producer incidence (share) of the tax is equal to area B - (P1-P3) x Q2
The QD in this market has decreased from Q1→Q2
If the decrease in QD is significant enough, it may force producers to lay off some workers
Examiner Tips and Tricks
When drawing this diagram, students often find it hard to identify the three price points.
The tax incidence boxes are formed by drawing the new equilibrium quantity through the original supply curve. The three price points are the old equilibrium point, new equilibrium point - and where the new quantity crosses the original supply curve.
Irrespective if you are dealing with taxes or subsidies, always use the new equilibrium point to determine your incidence boxes.
The consumer incidence is paid from the consumer surplus area and the producer incidence is paid from the producer surplus area.
A side by side comparison of the impact of PED on tax incidence
Aiming to maximise their profits, producers pass on as much of the indirect tax as they can to consumers and pay the balance themselves
The amount passed on to consumers depends on the price elasticity of demand (PED) of the product
Diagram analysis
In both diagrams, the specific tax shifts the supply curve from S1→S2
There is a higher market price at P2 and lower QD at Q2
Tax revenue for the government is the sum of A+B
Consumer incidence is represented by A and producer incidence by B
Total revenue for the seller is calculated using P3 X Q2
The difference in PED results in a different steepness to the demand curve
For a price inelastic product (e.g. cigarettes), producers pass on a much higher proportion of the tax to consumers (A) and pay the rest themselves (B)
The QD decreases (Q1→Q2) but by a much smaller proportion than the increase in price (P1→P2)
For a price elastic product (e.g. pizza), producers pass on a much smaller proportion of the tax to consumers (A) and pay the rest themselves (B)
The QD decreases (Q1→Q2) but by a much larger proportion than the increase in price (P1→P2)
Examiner Tips and Tricks
When asked to evaluate the impact of a tax in a particular market, it is essential to apply knowledge of PED to the impact it will have on producers, consumers and the government.
It should be obvious from the context if the product in the question is price elastic or inelastic in demand. If not, work through the factors that determine PED and make a judgement as to whether the product is price elastic or inelastic in demand. In your answer, explain your reasoning.
Subsidies
A producer subsidy is a per unit amount of money given to a firm by the government
To increase production
To increase provision of a merit good
The incidence (share) of the subsidy is determined by the PED of the product
If governments subsidise goods/services with high PED, the increase in QD will be more than proportional to the decrease in price
Producers keep some of the subsidy and pass the rest on to the consumers
Diagram analysis
The original equilibrium is at P1Q1
The subsidy shifts the supply curve from S → S + subsidy:
This increases the QD in the market from Q1→Q2
The new market equilibrium is P2Q2
This is a lower price and higher QD in the market
Producers receive P2 from the consumer PLUS the subsidy per unit from the government
Producer revenue is therefore P3 x Q2
Producer incidence of the subsidy is marked B in the diagram
The subsidy decreases the price that consumers pay from P1 → P2
Consumer incidence of the subsidy is marked A in the diagram
The total cost to the government of the subsidy is (P3 - P2) x Q2 represented by area A+B
Examiner Tips and Tricks
Memorise the distinction below as students get very confused when answering questions on subsidies.
When dealing with a subsidy, the producer benefit is now the top portion of the incidence area and consumer incidence is below. This can be confusing as in all other diagrams, it is the other way around (surplus, indirect tax etc.)
Logically, it makes sense. Producers are given an extra amount of money for each unit by the government so this raises the sales revenue they receive, while at the same time lowering the price consumers pay.
Last updated:
You've read 0 of your 10 free revision notes
Unlock more, it's free!
Did this page help you?
