Indirect taxes and subsidies

A) Supply and demand analysis, elasticities, and:

  • The impact of indirect taxes on consumers, producers and government
  • The incidence of indirect taxes on consumers and producers
  • The impact of subsidies on consumers, producers and government
  • The area that represents the producer subsidy and consumer subsidy



An indirect tax is a type of tax such as VAT that consumers don’t directly pay as it has been added onto the good/service already. Furthermore, consumers are not forced to pay the tax as they don’t have to buy the good/service. The revenue gained from that tax goes to the government. The indirect tax increases the production costs for firms, part of which is passed onto the consumer in the form of higher prices helping to reduce production as well as consumption of the good/service. The two types of indirect tax include Ad valorem tax and Specific tax. Ad valorem taxes are percentages which are added to certain products. For example VAT in the UK is 20% which is then added onto the original price. Ad valorem taxes are shown by two supply lines that get further and further away from each other. This is due to the fact that as the price of the good/service increases, the more the Ad valorem tax increases. This can be seen on the diagram below:

Ad valorem tax

This is in contrast to a specific tax where the amount of tax paid is the same regardless of the price of the good/service. As a result of this, a specific tax is shown by two parallel supply lines where supply decreases, as shown in the diagram below:

Indirect tax new

This diagram shows a specific tax. The specific tax increases production costs for the firm and therefore supply decreases from S1 to S1+tax. This causes price to increase from P1 to P1. As a result, quantity decreases from Q1 to Q2 thus helping to reduce consumption as well as production of the good/service. This is the reason why taxes are usually placed on goods such as cigarettes which harm society. This topic is covered in more detail later on in the course under the topics de-merit goods and market failure. The vertical difference between S1 and S1+tax represents the value of the tax per unit. Therefore by multiplying the tax per unit by the quantity of goods sold you are able to work out the government revenue gained by the specific tax (P2-d-c-b). Although the specific tax is placed on the producer, some of this cost will also be passed onto the consumer (P2-d-e-P1). As a result of this, the price that the consumer pays will increase from P1 to P2. The burden of tax that the producer pays is represented by the area P1-e-c-b). This causes producer revenue to fall from P1-a-Q1-0 to b-c-Q2-0. In addition to this, there is also a welfare loss to society. This welfare loss can be shown on the diagram below.

Taxation welfare loss diagram

  Free market Tax






0 B+C



In the free market the consumer surplus is the area above the market price (B+C+E). The producer surplus is the area below the market price (C+D+F). Therefore the total surplus is A+B+C+E+F. The government revenue in the free market is 0 as the tax hasn’t been implemented yet. After the tax has been applied, consumer surplus falls from A+B+E to just A. This is due to the rise in the market price caused by the tax from P1 to P2. Furthermore, producer surplus falls from C+D+F to just D. This is due to the tax B+C meaning the producer no longer gains the profit of C+F. The government revenue after the tax is equal to B+C (the difference between P2 and PT multiplied by quantity Q2). This means that the total surplus after the tax has been implemented is A+B+C+D. As you may have noticed this means that area E+F is no longer accounted for. As a result of this, there has been a deadweight welfare loss of area E+B. This means that overall; society is worse off as a result of the implementation of the indirect tax.


Indirect tax –inelastic demand

Indirect tax inelastic demand

If a tax is implemented on a good/service that is relatively price inelastic it will result in a large increase in price (P1 to P2), but only a small decrease in quantity (Q1 to Q2). Therefore the effect of a tax used on a price inelastic good/service is relatively ineffective when trying to decrease the consumption/production of that product. Furthermore, the consumer takes the majority of the burden. This can be shown by the consumer area P2-d-e-P1 being much larger than the producer area (P1-e-c-b). This shows that the majority of the increased cost caused by the tax is passed onto the consumer in the form of a higher price (P1 to P2). The reason for this is that producers know that the good/service they sell is price inelastic and therefore they know that they are able to increase their prices without suffering from a large decrease in quantity (the change in quantity is less than proportional to the change in price). For example, goods such as cigarettes that are addictive have a low price elasticity of demand. This means that despite a large increase in price (P1 to P2) consumers are unwilling to reduce the quantity of cigarettes that they consume by a significant amount as they’re addictive. However, the benefit to the government of implementing an indirect tax on price inelastic goods/service is that they produce a much larger amount of government revenue (P2-d-c-b) than indirect taxes placed on price elastic goods.


Indirect tax – elastic demand

Indirect tax elastic demand

When taxing goods/services that are price elastic, the reduction in supply caused by the tax (S1 to S1+Tax) has little impact on price (P1 to P2), but a big impact on the quantity consumed and supplied (Q1 to Q2). This allows only a small tax to be implemented in order to cause a large reduction in the consumption or production of a good/service. Therefore taxation is usually a good policy to implement if demand is elastic when trying to reduce negative externalities. The increased costs that are passed onto consumers are small compared to the burden that the producer pays. This is because firms know that a small increase in price will reduce quantity demanded massively. Therefore it is rational for firms to try and absorb as much of the increased cost as possible in order to try and reduce the extent to which quantity falls. This can be shown by the small area of consumer burden (P2-d-e-P1) compared to that of the producer burden (P1-e-c-b). The large fall in quantity (Q1 to Q2) means that the total government revenue from the indirect tax (P2-d-c-b) is much less than if the good/service was price inelastic. This is because far less people are now buying the good/service and therefore far less people are paying the indirect tax. Furthermore, the quantity of good/service being produced has also decreased from Q1 to Q2 meaning there are less goods/service to place the indirect tax onto.   



A subsidy is a certain amount of money given to a firm by the government in order to try and increase production or consumption of a good/service. This is due to the fact that some of the subsidy is kept by the firm thus increasing their profits and incentivising more firms to enter the market and those currently in the market to produce more. Furthermore, some of the subsidy is passed on to the consumer allowing firms to offer the good/service at a lower price causing an increase in quantity demanded.

Subsidy diagram

This can be shown on the diagram above as the subsidy lowers costs of production causing supply to increase from S1 to S1+Sub. As a result of this, price decreases from P1 to P2 and quantity increases from Q1 to Q2. This is because the introduction of a subsidy means that firms are more incentivised to produce more of the good/service and those firms that weren’t currently in the market are more incentivised to join the market. The cost of the subsidy to the government per unit is shown by the vertical difference between S1 and S1+Sub. Using this you can work out the total cost of the subsidy to the government by multiplying the subsidy cost per unit by the quantity Q2. This can be shown by the area a-b-c-P2. Unlike the tax diagram the producer area is on top and the consumer area is on the bottom. Consumers before the subsidy were paying price P1 at a quantity of Q1. They’re now paying price P2 at a quantity of Q2. This means the overall consumer saving from the subsidy is P1-d-e-P2. Although the intention of a subsidy is usually to reduce the price for consumers, the producers also keep some of the subsidy. Before the subsidy, producers were getting P1-d-Q1-0. After the subsidy Producers are getting 0-a-b-Q2 and therefore gaining the extra revenue of a-b-c-P2. The welfare loss is shown by the area d-b-c and can be explained using the diagram below.

Subsidy welfare loss diagram

  Free market Subsidy






0 B+E+C+F+G+H



In the free market consumer surplus is A+B, which is the area above the market price (P1). After the subsidy market price decreases to P2 causing consumer surplus to increase to A+B+C+F+G (the area above P2 within the demand curve). Producer surplus increases from C+D to B+C+D+E (the area below PS and above S1). This is due to the fact that the producer keeps some of the subsidy giving them a producer surplus up to price PS rather than P2.

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