Indirect Taxes & Subsidies

⭐ HIGH PRIORITY — Step-by-step tax incidence diagram, subsidy diagram, deadweight welfare loss, and who bears the burden

SPEC 1.1 • INTRODUCTION TO MARKETS

Key Definitions

Indirect Tax

A tax levied on the expenditure of goods and services, paid to the government by the producer but which can be partly or fully passed on to the consumer through higher prices. The tax creates a wedge between the price paid by the consumer and the price received by the producer.

Subsidy

A payment by the government to producers that reduces their costs of production, enabling them to supply at a lower price. It shifts the supply curve to the right (downward), reducing market price and increasing quantity.

Key Point

Indirect taxes shift supply left/upward (costs increase). Subsidies shift supply right/downward (costs decrease). They are mirror-image policies.

Specific vs Ad Valorem Taxes

There are two types of indirect tax. The distinction matters because they shift the supply curve differently.

Specific TaxAd Valorem Tax

DefinitionA fixed amount per unit soldA percentage of the selling price

Diagram effectS shifts parallel upward (constant gap)S pivots upward from intercept (widening gap)

UK exampleTobacco duty (£6.52 per pack, 2024)VAT (20% of price)

Revenue when P risesSame per unit regardless of priceIncreases as price rises

Examiner Alert

If the question says "specific tax," draw a parallel shift. If it says "ad valorem" or "VAT," draw a pivoting shift from the same Y-intercept. Getting this wrong loses a diagram mark immediately.

Specific Tax Diagram — Step by Step

This is the most tested diagram in Theme 1. Follow these 6 steps in order every time.

Reading the Tax Diagram — 6 Steps

1Draw original S₁ and D. Mark equilibrium E₁ at P₁, Q₁. Dotted lines to both axes.

2Shift S upward by the tax amount. For a specific tax: parallel shift. Label new curve S₁+tax. The vertical distance between S₁ and S₁+tax = amount of tax per unit.

3Mark new equilibrium E₂. Where S₁+tax crosses D. New price is Pc (consumer price) at new quantity Q₂.

4Find the producer price Pp. Drop down from Q₂ to the original S₁ curve. This is what producers actually receive after paying the tax. Pp = Pc − tax.

5Identify tax incidence. Consumer burden = Pc − P₁ (price rise). Producer burden = P₁ − Pp (price fall). Total tax = Pc − Pp.

6Shade areas. Government revenue = rectangle (Pc − Pp) × Q₂. Deadweight loss = triangle between Q₂ and Q₁.

Examiner Alert

The #1 error on this diagram (from examiner reports): students only show the supply shift but fail to label Pc, Pp, consumer incidence, and producer incidence separately. Showing only the shift without identifying WHO bears the burden scores max 2/4 on a diagram question.

Who Bears the Burden? — PED & PES

The relative elasticity of demand and supply determines how the tax burden is split between consumers and producers.

Inelastic Demand → Consumers Pay More

If PED is inelastic (e.g. cigarettes, petrol), consumers cannot easily reduce consumption. Producers can pass most of the tax on as higher prices.

Result: Pc rises significantly, Pp falls only slightly. Most of the tax burden falls on consumers.

Elastic Demand → Producers Pay More

If PED is elastic (e.g. luxury goods, goods with close substitutes), consumers switch away easily. Producers must absorb the tax to stay competitive.

Result: Pc rises only slightly, Pp falls significantly. Most of the tax burden falls on producers.

The General Rule

The more inelastic side of the market bears the greater burden of the tax. This applies to both PED and PES. If supply is perfectly elastic, consumers bear 100% of the tax. If demand is perfectly inelastic, consumers bear 100%.

Exam Tip

This is one of the highest-yield evaluation points in all of Theme 1. In any tax question, write: "The incidence of the tax depends on the relative elasticity of demand and supply..." and develop for 3+ sentences. Instant Level 3+ evaluation.

Tax with Inelastic Demand

When demand is inelastic, the tax is mostly passed to consumers — the consumer price rises by nearly the full amount of the tax.

Tax on cigarettes

PED inelastic (addictive)

Consumers can't switch

Producers pass on most of tax

Price rises nearly by full tax

Government Revenue & Deadweight Loss

The tax generates two areas on the diagram that you must identify:

Government Revenue (Rectangle)

Area = (Pc − Pp) × Q₂

This is the tax per unit multiplied by the number of units sold. It's a transfer from consumers and producers to the government — not a net welfare loss.

Part comes from consumer surplus (they pay more) and part from producer surplus (they receive less).

Deadweight Welfare Loss (Triangle)

Area = ½ × (Q₁ − Q₂) × (Pc − Pp)

This represents trades between Q₂ and Q₁ that no longer take place. These would have been mutually beneficial but are now prevented by the tax.

DWL is a net loss to society — not transferred to anyone.

Net Welfare Change = −(DWL) because Gov Revenue is a transfer, not a loss

Exam Tip

When calculating government revenue, use the new quantity Q₂, not Q₁. A common error is using original quantity — but fewer units are sold after the tax.

Subsidy Diagram — Step by Step

A subsidy is the mirror image of a tax. It shifts supply downward/right by the subsidy amount per unit.

Reading the Subsidy Diagram

1S shifts downward by the subsidy amount → S₁ to S₁−sub. Supply increases because costs are reduced.

2New equilibrium E₂: where S₁−sub crosses D. Consumer price falls to Pc, quantity rises to Q₂.

3Producer price Pp: go up from Q₂ to the original S₁. Producers receive Pc from consumers PLUS the subsidy = Pp. So Pp > P₁ (producers are better off).

4Government cost: rectangle = (Pp − Pc) × Q₂. This is the total subsidy expenditure.

Consumer Benefit

Pay lower price (P₁ → Pc). CS increases. The benefit to consumers depends on PED — if demand is elastic, consumers gain more from the lower price.

Producer Benefit

Receive higher effective price (P₁ → Pp) and sell more units (Q₁ → Q₂). PS increases. The benefit depends on PES.

Tax vs Subsidy — Side by Side

Indirect TaxSubsidy

Supply curveShifts up/leftShifts down/right

Consumer priceRises (Pc > P₁)Falls (Pc < P₁)

Producer priceFalls (Pp < P₁)Rises (Pp > P₁)

QuantityFalls (Q₂ < Q₁)Rises (Q₂ > Q₁)

CSDecreasesIncreases

PSDecreasesIncreases

Gov't budgetRevenue gainedCost incurred

WelfareDWL trianglePossible over-production loss

Why Use Indirect Taxes & Subsidies?

Indirect Tax Purposes

Raise revenue for government spending

Correct negative externalities — internalise the external cost (e.g. carbon tax)

Discourage consumption of demerit goods (e.g. sugar tax, alcohol duty)

Redistribute income — tax luxury goods more

Subsidy Purposes

Correct positive externalities — increase consumption of merit goods (e.g. education, healthcare)

Lower cost of living — subsidise essential goods (e.g. energy subsidies)

Support producers — protect domestic industry (e.g. agricultural subsidies)

Encourage investment — R&D subsidies for green technology

Market failure identified

Gov't applies tax/subsidy

S curve shifts to correct Q

Move toward socially optimal output

Worked Calculation

1

Tax Incidence & Revenue

A specific tax of £3 per unit is placed on a good. Before the tax: P₁ = £10, Q₁ = 1,000 units. After the tax: Pc = £12, Q₂ = 800 units.

(a) Calculate the producer price after the tax.

Pp = Pc − tax = £12 − £3 = £9

(b) Calculate consumer and producer incidence.

Consumer incidence = Pc − P₁ = £12 − £10 = £2 per unit (consumers bear £2 of the £3 tax)

Producer incidence = P₁ − Pp = £10 − £9 = £1 per unit (producers bear £1 of the £3 tax)

(c) Calculate government revenue.

Gov Revenue = Tax × Q₂ = £3 × 800 = £2,400

(d) Calculate deadweight loss.

DWL = ½ × (Q₁ − Q₂) × Tax = ½ × 200 × £3 = £300

Practice Question

Question: The UK government places a specific tax of £2 per unit on sugary drinks. Before the tax, the equilibrium price was £1.50 and quantity was 5 million units. After the tax, the consumer price rises to £2.80 and quantity falls to 3.5 million units.

(a) Calculate the producer price, government revenue, and deadweight loss. (6 marks)

(b) Explain why the consumer bears the larger share of the tax burden. (4 marks)

(a)

Pp = £2.80 − £2.00 = £0.80

Consumer incidence = £2.80 − £1.50 = £1.30 per unit

Producer incidence = £1.50 − £0.80 = £0.70 per unit

Gov Revenue = £2.00 × 3.5m = £7 million

DWL = ½ × (5m − 3.5m) × £2 = ½ × 1.5m × 2 = £1.5 million

(b)

Consumers bear £1.30 of the £2.00 tax (65%). This is because the demand for sugary drinks is relatively price inelastic — consumers are habituated to sugar consumption and perceive few close substitutes. Because they cannot easily reduce their quantity demanded, producers are able to pass on the majority of the tax through higher prices. As shown in the diagram, the steep demand curve means the new equilibrium price Pc is much closer to P₁ + full tax than to P₁.

Examiner Alert — Common Errors

Most Common Mistakes

Not labelling Pc AND Pp separately — this is the single most common error. You MUST show both the consumer price and the producer price. Just showing "P₂" loses incidence marks

Drawing ad valorem shift for a specific tax — specific = parallel shift; ad valorem = pivot from intercept

Using Q₁ to calculate government revenue — revenue = tax × Q₂ (NEW quantity), not the original

Saying "the tax falls on producers because they pay it" — legally producers remit the tax, but economically the burden is shared. Incidence depends on elasticity

Not shading the DWL triangle — identify and shade the triangle between E₁, E₂, and the point on S₁ at Q₂

Forgetting subsidy = government COST — unlike a tax (revenue), a subsidy requires spending. Always mention the opportunity cost of this expenditure

Confusing direction of subsidy shift — subsidy shifts S right/downward (lower price), NOT left

AO4 Evaluation Toolkit — Taxes & Subsidies

Eval 1: Elasticity Determines Incidence

"The effectiveness of the tax depends on PED. If demand is inelastic, quantity falls only slightly → limited reduction in consumption → most of the burden falls on consumers rather than changing behaviour."

Eval 2: Regressive Nature

"Indirect taxes are regressive — they take a larger proportion of income from low-income households. A sugar tax hits the poorest hardest, worsening income inequality even if it corrects a market failure."

Eval 3: Government Failure

"The government may lack the information to set the tax at the correct level. Over-taxation creates excessive DWL; under-taxation fails to correct the externality. There is also the risk of regulatory capture by lobbying industries."

Eval 4: Subsidy Opportunity Cost

"Subsidies have an opportunity cost — the money spent could fund healthcare, education, or debt reduction. Moreover, subsidies can create dependency and reduce firms' incentives to innovate or become efficient."

Eval 5: Alternative Policies

"An indirect tax is not the only option. The government could use regulation (bans), information provision (labelling), or tradable permits. Each has different welfare implications and administrative costs."

Ad Valorem Tax — The Pivot

VAT is the UK's main ad valorem tax (20%). Because it's a percentage of price, the tax per unit increases as price increases — creating a widening gap between S₁ and S₁+tax.

Key Point

For ad valorem taxes, S₁ and S₁+tax share the same Y-intercept (at zero price, 20% of zero = zero tax). The gap widens as price increases. This is the visual difference from a specific tax.

Summary

Key Takeaways

ConceptDetail

Indirect TaxShifts S left/up. Pc rises, Pp falls, Q falls, DWL created

SubsidyShifts S right/down. Pc falls, Pp rises, Q rises, gov't cost

Specific TaxFixed £ per unit → parallel shift

Ad Valorem% of price → pivot from same intercept

Tax IncidenceMore inelastic side bears greater burden

Gov Revenue= Tax per unit × Q₂ (rectangle)

DWL= ½ × (Q₁−Q₂) × Tax (triangle)

The Diagram Checklist

S₁, S₁+tax/sub, D labelled

E₁ and E₂

Pc AND Pp on Y-axis

Q₁ and Q₂ on X-axis

Gov revenue shaded

DWL shaded

Incidence labelled

The #1 Evaluation Point

"The effectiveness depends on PED — if demand is inelastic, the tax raises revenue but fails to significantly reduce consumption, which may be the government's primary objective."

Exam Tip

This topic appears on almost every Paper 1. Master the specific tax diagram with full annotations (Pc, Pp, revenue rectangle, DWL triangle, incidence labels) and you have a ready-made answer for 4–15 mark questions.