Indirect Taxes and Subsidies
In one line. An indirect tax shifts supply up and left, a parallel shift for a specific tax and a pivot for an ad valorem tax, raising price and cutting quantity. The tax incidence, how the burden splits between consumers and producers, depends on the price elasticity of demand, with more passed on when demand is inelastic. A subsidy shifts supply right, lowering price and raising quantity.
Exam relevance: a core A Level Economics topic, on ETG analysis of the last ten years. Taught the way an economics tutor who wrote the answer keys teaches it.
01What an indirect tax is
An indirect tax is a tax on spending, levied on a good or service, and on a demand and supply diagram it works by shifting the supply curve.
An indirect tax is a tax on the production or sale of a good, paid to the government by the producer but partly passed on to the consumer in a higher price. A subsidy is a payment from the government that lowers the cost of supply.
Because the tax adds to the cost of supplying each unit, it is modelled as an upward, leftward shift of supply, not a movement along it. Everything else follows from that shift.
02The effect of an indirect tax
A tax raises the price consumers pay and lowers the quantity traded, and the diagram shows how the burden is shared.
Supply shifts up by the tax, so the equilibrium price rises and quantity falls. The vertical distance between the old and new supply curves at the new quantity is the tax per unit. Part of that distance is the rise in the price consumers pay, and the rest is the fall in the net price producers keep, which is how the diagram splits the burden.
03Specific versus ad valorem
The two kinds of indirect tax shift supply in different shapes, and drawing the wrong one is a frequent error.
- A specific tax is a fixed amount per unit, so it shifts supply up by the same vertical distance at every quantity: a parallel shift.
- An ad valorem tax is a percentage of the price, so the absolute amount grows with price: the supply curve pivots, widening at higher prices. The GST is an ad valorem tax.
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04Tax incidence and elasticity
How the tax burden is divided between consumers and producers, the tax incidence, is decided by the price elasticity of demand.
When demand is price inelastic, consumers respond little to the higher price, so producers can pass most of the tax on; the consumer share of the incidence is large. When demand is price elastic, consumers cut back sharply if the price rises, so producers must absorb more of the tax to avoid losing sales; the producer share is large. The same logic runs through elasticity of supply. This is why a tax on a necessity such as fuel falls mostly on consumers, while a tax on a good with many substitutes falls more on producers.
05Subsidies
A subsidy is the mirror image of an indirect tax: it lowers the cost of supply and so shifts the supply curve the other way.
A per unit subsidy shifts supply down and to the right by the amount of the subsidy. The price consumers pay falls and the equilibrium quantity rises, while producers receive the lower market price plus the subsidy from the government. As with a tax, the benefit is split between consumers and producers according to the elasticities, and the government bears the fiscal cost. Subsidies are used to encourage output of goods judged socially desirable, the link forward to merit goods and positive externalities.
06Common misconceptions
Do not draw a parallel shift for an ad valorem tax; it pivots. And do not assume the full tax is always passed to consumers. Full pass-through requires perfectly inelastic demand, which is a theoretical extreme, so in almost every real case the burden is shared.
07Test yourself
- Using a diagram, explain how a specific tax changes the equilibrium price and quantity of a good.
- Explain why a larger share of an indirect tax is passed to consumers when demand is more inelastic.
- Explain how a subsidy changes the price consumers pay and the quantity traded.
Key terms on this page
Indirect taxSpecific taxAd valorem taxTax incidenceSubsidyPrice elasticity of demand
08Questions students ask
An indirect tax raises the cost of supplying each unit, so it shifts the supply curve up and to the left by the amount of the tax. The equilibrium price rises and the equilibrium quantity falls. A specific tax shifts supply up by a constant amount, a parallel shift; an ad valorem tax is a percentage of price, so it pivots the supply curve, widening at higher prices.
Tax incidence is how the burden of an indirect tax is split between consumers, who pay through a higher price, and producers, who absorb the rest in a lower net price. The split depends on the price elasticity of demand. The more inelastic demand is, the larger the share passed on to consumers; the more elastic demand is, the more producers must absorb.
A subsidy is the reverse of an indirect tax. It lowers the cost of supplying each unit, so it shifts the supply curve down and to the right. The price consumers pay falls and the equilibrium quantity rises; producers receive the lower market price plus the subsidy. The government bears the fiscal cost, and the benefit is split between consumers and producers according to elasticity.