A) Indirect taxes

An indirect tax is placed on a good or service and increases the cost of production for firms. Some of this additional cost may be passed on to consumers through higher prices.

Indirect taxes can therefore reduce both the production and consumption of a good or service. The revenue raised from the tax is received by the government.

Two types of indirect tax are ad valorem taxes and specific taxes.

B) Ad valorem and specific taxes

Ad valorem tax

An ad valorem tax is charged as a percentage of the value of the good or service. This means that the amount of tax increases as the price of the product increases.

The tax raises firms’ costs of production and reduces supply. The market price rises while the equilibrium quantity falls.

Specific tax

A specific tax is a fixed amount of tax charged per unit of a good or service. Unlike an ad valorem tax, the amount paid per unit does not change with the price of the product.

In the diagram, the tax increases production costs and shifts supply from S1 to S1+Tax. The market price rises and the quantity bought and sold falls.

The vertical distance between the two supply curves represents the tax charged per unit.

C) Subsidies

A subsidy is money provided by the government to a firm in order to encourage greater production or consumption of a good or service.

A subsidy reduces firms’ costs of production. This gives existing firms an incentive to increase output and may also encourage more firms to enter the market.

In the diagram, the subsidy causes supply to increase from S1 to S1+Sub. As a result, the market price falls from P1 to P2 and quantity increases from Q1 to Q2.

Consumers therefore benefit from a lower price, while producers also receive part of the subsidy.

What the full guide adds

For this topic, the full AS guide also covers:

• The incidence of indirect taxation, including how the burden of a tax is divided between consumers and producers.
• How to calculate and identify government tax revenue, consumer surplus, producer surplus and welfare loss on an indirect-tax diagram.
• How price elasticity of demand affects tax incidence, including separate analysis of relatively elastic and relatively inelastic demand.
• Why an indirect tax can have different effects on price, quantity and government revenue depending on the elasticity of demand.
• The full subsidy analysis, including the consumer and producer shares of a subsidy, the total cost to government and the resulting welfare loss.
• How the effect of a subsidy changes when demand is relatively elastic or relatively inelastic.
• Additional diagrams showing the detailed welfare and incidence effects of taxes and subsidies.