Understanding indirect taxes and subsidies is key to analysing how governments influence markets and resource allocation through fiscal measures.
What are indirect taxes?
Indirect taxes are taxes levied on goods and services rather than directly on income or wealth. Unlike direct taxes which are paid straight to the government by individuals or firms (e.g. income tax or corporation tax), indirect taxes are collected by an intermediary (such as a retailer or producer) and passed on to the government. The economic burden of the tax may be shared between the buyer and the seller, depending on price elasticity.
Examples of indirect taxes
Value Added Tax (VAT) – A consumption tax placed on a product whenever value is added at each stage of the supply chain, typically paid by the final consumer.
Excise duties – Specific taxes on particular goods like alcohol, tobacco, and fuel.
Customs duties – Taxes on imported goods to protect domestic industries or raise revenue.
Characteristics of indirect taxes
Often regressive – lower-income individuals pay a greater proportion of their income.
Typically affect the supply side by increasing costs for producers.
Create a wedge between what consumers pay and what producers receive.
Used by governments to correct market failures (e.g. negative externalities) and raise revenue.
What are subsidies?
Subsidies are financial support provided by the government to reduce costs for producers or consumers. Their purpose is to encourage the production or consumption of certain goods and services that have positive externalities or wider social benefits.
Types of subsidies
Producer subsidies – Reduce the costs of production and encourage firms to increase supply.
Consumer subsidies – Lower the price for consumers, making goods and services more affordable.
Objectives of subsidies
Promote the consumption of merit goods (e.g. education, healthcare).
Encourage positive externalities (e.g. subsidies for electric vehicles).
Support domestic industries and protect employment.
Enhance equity and affordability.
The impact of indirect taxes on market equilibrium
How an indirect tax affects supply
When an indirect tax is imposed, it increases the cost of production for firms. This leads to a decrease in supply, shown as an upward or leftward shift of the supply curve.
Supply and demand diagram explanation
Initial supply curve: S1
New supply curve with tax: S2 (shifted left/upwards)
Initial equilibrium: E1 (price P1, quantity Q1)
New equilibrium: E2 (price P2, quantity Q2)
Outcomes of imposing a tax
Price rises from P1 to P2.
Quantity traded falls from Q1 to Q2.
Consumer burden: The part of the price increase paid by buyers.
Producer burden: The part of the tax not passed on to consumers and absorbed by sellers.
Government revenue: Equal to the tax per unit multiplied by the quantity sold after the tax is imposed (Q2).
Government revenue area
This can be shown as a rectangle between the two supply curves (S1 and S2), with height equal to the tax per unit and width equal to Q2.
The impact of subsidies on market equilibrium
How a subsidy affects supply
A subsidy reduces the cost of production. This causes the supply curve to shift downwards or to the right as firms are willing to supply more at each price level.
Supply and demand diagram explanation
Original supply curve: S1
New supply curve after subsidy: S2 (shifted right/downward)
Original equilibrium: E1 (price P1, quantity Q1)
New equilibrium: E2 (price P2, quantity Q2)
Outcomes of providing a subsidy
Price falls from P1 to P2.
Quantity exchanged increases from Q1 to Q2.
Consumers benefit from lower prices.
Producers benefit from higher revenues and increased sales.
Government expenditure equals the subsidy per unit multiplied by Q2.
Government expenditure area
This is represented by a rectangle between S1 and S2, with height equal to the subsidy and width equal to Q2.
Incidence of tax and subsidy: the role of elasticity
The incidence of a tax or subsidy refers to how the economic burden or benefit is distributed between consumers and producers. The key determinant of incidence is the price elasticity of demand and price elasticity of supply.
Tax incidence and elasticity of demand
More inelastic demand (steeper demand curve)
Consumers are less responsive to price changes.
A greater share of the tax burden is passed on to consumers through higher prices.
Examples: petrol, tobacco – demand does not fall much even when prices rise.
More elastic demand (flatter demand curve)
Consumers are more responsive to price changes.
Producers bear a greater share of the tax burden, as passing on the tax would significantly reduce quantity demanded.
Example: luxury goods – demand is sensitive to price changes.
Tax incidence and elasticity of supply
More inelastic supply
Producers cannot easily change the quantity supplied.
Producers bear more of the tax burden.
More elastic supply
Producers can more easily adjust production.
Consumers bear more of the tax burden as producers pass on more of the cost.
Subsidy incidence and elasticity
More inelastic demand
Consumers benefit more – the subsidy significantly reduces the price they pay.
Quantity increases only slightly.
More elastic demand
Producers gain a larger benefit – quantity sold increases significantly.
The price does not fall as much for consumers.
More inelastic supply
Producers cannot expand output easily, so they receive more of the subsidy benefit.
More elastic supply
Producers increase output significantly, leading to greater benefit for consumers through lower prices.
Graphical representation of incidence
Tax incidence diagram
Vertical distance between S1 and S2 represents tax per unit.
The price rises from P1 to P2 – the area between the original price and the new price up to Q2 shows the consumer burden.
The area between S1 and the original price, up to Q2, shows the producer burden.
The combined area (consumer + producer burden) equals total government revenue.
For example:
If a £2 per unit tax is imposed and the price increases by £1.20, then consumers bear 60% of the tax, and producers bear 40%.
Subsidy incidence diagram
Vertical distance between S1 and S2 represents subsidy per unit.
Price falls from P1 to P2 – the area between the original price and the new price, up to Q2, shows the consumer benefit.
The area between the new supply curve and the original supply curve, above the new price, shows the producer benefit.
The total of these areas represents government spending on the subsidy.
For example:
If a £3 subsidy per unit causes the price to fall by £1.80, consumers benefit by 60% and producers by 40%.
Real-world applications of indirect taxes
Demerit goods
Governments use indirect taxes to reduce the consumption of demerit goods that have negative externalities.
Tobacco: Highly taxed due to health impacts.
Petrol: Taxed to reduce pollution and congestion.
Since demand for these goods is inelastic, consumers pay most of the tax, making it an effective policy tool and a reliable source of government revenue.
Revenue generation
Indirect taxes are often preferred due to ease of collection and their ability to generate large sums of revenue.
VAT is a major revenue source in most countries.
Excise duties are predictable and administratively simple.
Real-world applications of subsidies
Merit goods and positive externalities
Subsidies are used to promote the consumption or production of merit goods.
Public transport: Subsidies reduce fares and encourage use, helping to reduce emissions.
Green energy: Encourages investment in renewable energy sources.
Education and healthcare: Make essential services more affordable and accessible.
Supporting industries and employment
Governments may provide subsidies to:
Struggling industries during economic downturns.
Encourage research and development.
Protect jobs and maintain economic stability.
Importance of elasticity in government policy
Policy effectiveness
Understanding elasticity is crucial in policy design:
Taxes on inelastic goods minimise welfare loss and maximise revenue.
Subsidies on elastic goods produce large increases in output.
Revenue and spending predictability
Elasticity helps predict how changes in price will affect quantity demanded or supplied, allowing better forecasting of revenue from taxes and costs of subsidies.
Equity and efficiency trade-offs
Policymakers must consider whether the incidence of a tax or subsidy is fair (equity) and whether it leads to the optimal allocation of resources (efficiency).
For instance:
A regressive tax on fuel may disproportionately affect low-income households.
A well-targeted subsidy for education can improve long-term productivity and equity.
FAQ
Governments may choose specific taxes—a fixed amount per unit (e.g. £0.50 per litre of petrol)—over ad valorem taxes, which are a percentage of the price (e.g. 20% VAT), for several economic and administrative reasons. Firstly, specific taxes provide predictable and stable revenue regardless of changes in market prices, which helps governments plan budgets more accurately. Secondly, they are often used to target harmful consumption directly. For example, taxing cigarettes at £4 per pack discourages consumption, regardless of brand or retail price. This makes specific taxes ideal for correcting negative externalities, as the monetary deterrent remains constant across all product qualities. In contrast, ad valorem taxes are proportional to price, meaning luxury brands are taxed more heavily. This can create inconsistencies in targeting demerit goods. Additionally, specific taxes are easier to administer, as tax collection does not require constant price monitoring. However, one downside is that they do not adjust for inflation unless regularly updated by the government.
Indirect taxes and subsidies can significantly influence allocative efficiency, which occurs when resources are distributed to maximise societal welfare, where marginal social benefit (MSB) equals marginal social cost (MSC). Indirect taxes, particularly on demerit goods, can improve allocative efficiency by internalising negative externalities—bringing private costs closer to social costs. For instance, a tax on petrol accounts for environmental harm, encouraging lower consumption and reducing overproduction. This corrects market failure and moves the equilibrium output closer to the socially optimal level. Conversely, subsidies can enhance allocative efficiency when used on merit goods, like vaccinations or public transport, by lowering prices and increasing consumption. This aligns private benefits with higher social benefits. However, if applied indiscriminately, taxes can distort prices and cause deadweight loss, reducing efficiency. Similarly, poorly targeted subsidies may encourage overproduction, wasting scarce resources. Hence, while both tools have the potential to improve efficiency, their effectiveness depends on careful design and appropriate market application.
While subsidies aim to correct market failures, they can also cause government failure if they lead to inefficient outcomes. One common issue is misallocation of resources: if subsidies are given to politically influential but inefficient industries, they may encourage production that society does not value, leading to productive inefficiency. Another risk is overdependence, where firms rely on financial support instead of innovating or reducing costs. This weakens market discipline, making industries less competitive over time. Moreover, subsidies can strain public finances, particularly if they are expensive and widespread. High fiscal burdens may divert funds from essential services like healthcare or education. There's also the risk of opportunity cost, where the funds used for subsidies could have been better spent elsewhere. Additionally, subsidies can distort competition by favouring certain firms or sectors over others, leading to unfair advantages and reduced overall market efficiency. If subsidies are poorly targeted or not evaluated regularly, their long-term benefits may not justify the costs.
Time lags can significantly reduce the effectiveness of subsidies, particularly in dynamic or fast-changing markets. A time lag refers to the delay between a policy being implemented and its full impact being felt in the market. For subsidies, this lag can occur due to bureaucratic delays, slow producer responses, or investment lead times. For example, in renewable energy, subsidies may be announced for solar panel installation, but the actual supply response may take years due to the time required for infrastructure development, workforce training, or acquiring capital. During this delay, market conditions may change—such as shifts in technology or consumer preferences—which can render the original subsidy less effective or even redundant. Moreover, time lags make it harder to evaluate the success of subsidies promptly, risking continued funding for ineffective policies. In volatile markets, a well-intentioned subsidy might even exacerbate imbalances if it kicks in after the market has self-corrected or shifted direction.
Indirect taxes can affect consumer behaviour in ways that extend beyond just making products more expensive. Firstly, they send a strong price signal that a good is undesirable, particularly for products with social stigma like cigarettes or sugary drinks. This psychological effect may discourage consumption even if the price increase is minor. Secondly, consumers may engage in substitution behaviour, switching to untaxed or lower-tax alternatives (e.g. switching from sugary fizzy drinks to flavoured water), which can lead to market shifts. Indirect taxes can also promote greater price awareness. For example, if VAT is clearly itemised on receipts, consumers may become more conscious of what they are paying and question the value of purchases. Additionally, taxes can encourage long-term habit changes, especially if supported by public education campaigns. Finally, indirect taxes may also disproportionately affect lower-income groups, leading them to reduce consumption of even essential items if prices rise too much, raising concerns about equity and access.
Practice Questions
Explain how the incidence of an indirect tax depends on the price elasticity of demand and supply.
The incidence of an indirect tax is influenced by the relative price elasticity of demand and supply. When demand is price inelastic and supply is price elastic, consumers bear a greater burden of the tax, as they are less responsive to price changes. Conversely, if demand is elastic and supply is inelastic, producers bear more of the tax burden since consumers reduce quantity demanded significantly when prices rise. The steeper the demand curve and the flatter the supply curve, the greater the consumer burden, and vice versa. Tax incidence depends entirely on how responsive buyers and sellers are to price changes.
Using a diagram, explain the effects of a subsidy on market price and output.
A subsidy reduces production costs, causing the supply curve to shift rightward. This leads to a fall in market price and a rise in equilibrium quantity. Consumers benefit from lower prices, while producers sell more and receive additional revenue per unit, including the subsidy. The diagram shows a downward shift of the supply curve, a lower equilibrium price, and a higher output level. The extent of the change depends on the price elasticity of demand and supply. If demand is more elastic, the quantity increase is greater. The government pays the subsidy, with the benefit shared between consumers and producers.
