Indirect Taxes and Subsidies

This lesson covers the effects of indirect taxes and subsidies on markets, including how they shift supply curves, alter equilibrium price and quantity, affect consumer and producer surplus, create deadweight loss, and how the burden (incidence) of a tax depends on the elasticities of demand and supply. This is a core topic for AQA Paper 1.

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Types of Tax

Taxes are broadly classified as direct or indirect:

Type	Definition	Examples
Direct tax	Levied on income or wealth; paid directly to the government by the taxpayer	Income tax, corporation tax, capital gains tax, inheritance tax
Indirect tax	Levied on spending/expenditure; collected by the seller and passed to the government	VAT, excise duties (tobacco, alcohol, fuel), sugar tax, air passenger duty

This lesson focuses on indirect taxes, which affect the supply side of the market.

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Specific Taxes vs Ad Valorem Taxes

There are two types of indirect tax:

Specific Tax

Key Definition: A specific tax is a fixed amount of tax per unit sold, regardless of the selling price.

The supply curve shifts vertically upward by the amount of the tax — the gap between the old and new supply curves is constant at every quantity.

UK Examples: Excise duty on cigarettes (approximately £6.52 per pack of 20 in 2024); excise duty on petrol (52.95p per litre in 2024); the Soft Drinks Industry Levy (sugar tax) of 18p or 24p per litre depending on sugar content.

Ad Valorem Tax

Key Definition: An ad valorem tax is a percentage tax levied as a proportion of the selling price.

The supply curve shifts upward, but the gap between the old and new supply curves increases as the price increases (because the tax is a percentage of the price). The new supply curve diverges from the original.

UK Example: VAT (Value Added Tax) is the UK's main ad valorem tax, currently set at 20% (standard rate). The gap between the pre-tax and post-tax supply curves widens as the price increases.

Exam Tip: When drawing diagrams, show a specific tax as a parallel upward shift of the supply curve (constant vertical distance) and an ad valorem tax as a diverging upward shift (widening vertical distance). This distinction is commonly tested and easy marks if drawn correctly.

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The Effect of an Indirect Tax on Market Equilibrium

When an indirect tax is imposed:

1. The supply curve shifts upward (or leftward) from S1 to S1 + tax.
2. The new equilibrium has a higher price paid by consumers (Pc) and a lower quantity traded (Q2).
3. The price received by producers (Pp) is lower than the original equilibrium price — it equals the consumer price minus the tax.
4. The difference between Pc (consumer price) and Pp (producer price) equals the tax per unit.

Consumer Price vs Producer Price

After the tax:

• Consumer price (Pc): The price consumers actually pay — higher than the original equilibrium price.
• Producer price (Pp): The price producers actually receive after paying the tax — lower than the original equilibrium price.
• Tax revenue = tax per unit × quantity sold = (Pc - Pp) × Q2

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Tax Incidence: Who Bears the Burden?

Key Definition: Tax incidence refers to who ultimately bears the burden of a tax — consumers (through higher prices) or producers (through lower revenue per unit).

The incidence depends on the relative elasticities of demand and supply:

When Demand is Inelastic and Supply is Elastic

• Consumers bear most of the tax burden.
• The price rises significantly because consumers cannot easily reduce their consumption.
• Producers can reduce output relatively easily, so they pass most of the tax onto consumers.

UK Example: Excise duty on tobacco. Demand for cigarettes is inelastic (due to addiction), so tobacco companies can pass most of the tax on to smokers through higher prices. The government collects substantial revenue (over £10 billion per year from tobacco duties).

When Demand is Elastic and Supply is Inelastic

• Producers bear most of the tax burden.
• Consumers can easily switch to alternatives, so the price cannot rise much.
• Producers cannot easily reduce output, so they absorb the tax through lower revenue per unit.

Summary Table

Elasticity Scenario	Tax burden falls mainly on	Price rises by	Revenue raised
Demand inelastic, supply elastic	Consumers	Large amount	High
Demand elastic, supply inelastic	Producers	Small amount	Lower
Demand inelastic, supply inelastic	Shared, but more on consumers	Moderate	Moderate-high

Exam Tip: In tax incidence questions, always draw a diagram showing both the consumer price (Pc) and the producer price (Pp). The consumer burden is Pc - Pe (original equilibrium price). The producer burden is Pe - Pp. Show these clearly on your diagram. State which burden is larger and explain why with reference to elasticity.

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Welfare Effects of an Indirect Tax

An indirect tax reduces total welfare by creating a deadweight loss: