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Mixed Economic System » Indirect Taxes and Subsidies

What you'll learn this session

Study time: 30 minutes

Cambridge spec: 2.10.3

What an indirect tax and a subsidy are
How to draw and read a diagram for each one
How a tax can cut consumption of demerit goods
How a subsidy can raise consumption of merit goods
The advantages and disadvantages of both

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Changing the price through costs

In the last lesson the government set the price itself. There is a gentler way. The government can change what it costs producers to supply a good, and let the market do the rest. Two tools do this.

Key terms:

Indirect tax: a tax on spending on a good or service. The seller collects it and passes it to the government, so it is added to the cost of supplying the good.
Subsidy: money paid by the government to producers to lower their costs, so they supply more of a good at each price.

Remember that a rise in costs shifts the supply curve to the left, and a fall in costs shifts it to the right. A tax raises costs and a subsidy lowers them.

Indirect tax: the diagram

A government may put an indirect tax on a demerit good, or on a good with external costs, to cut how much of it is bought. Here is a made-up market for energy drinks in the country of Kolvane. The government adds a tax of $2 per can.

Price per can ($)	Quantity demanded (thousand cans)	Quantity supplied before tax, S (thousand cans)	Quantity supplied after tax, S₁ (thousand cans)
2	80	20	0
3	70	30	10
4	60	40	20
5	50	50	30
6	40	60	40
7	30	70	50

Firms must now charge $2 more to cover the tax, so at each price they supply what they used to supply at a price $2 lower.

Worked example

Before the tax, demand equals supply at $5, so the equilibrium price is $5 and the equilibrium quantity is 50 thousand cans.

After the tax, demand equals supply at $6, so the new equilibrium price is $6 and the new equilibrium quantity is 40 thousand cans.

The price rises by $1 and the quantity falls by 10 thousand cans.

The government collects $2 on each can sold: 40,000 × $2 = $80,000.

The price rises by less than the $2 tax. Producers take on the rest of the tax themselves, so they keep $4 per can instead of $5.

Follow these steps in the exam.

Draw the axes. Put Price on the vertical axis and Quantity on the horizontal axis.
Draw a downward sloping demand curve D and an upward sloping supply curve S. Mark the equilibrium price P₁ and quantity Q₁.
Draw a new supply curve S₁ to the left of S. It is also higher, because the cost has risen. The vertical gap between S and S₁ is the amount of the tax.
Mark where D meets S₁. Label the new price P₂ and quantity Q₂.
P₂ is higher than P₁ and Q₂ is lower than Q₁.

Advantages and disadvantages of indirect taxes

✅ Advantages

The higher price and lower quantity cut consumption of demerit goods.

It makes buyers and producers pay more for goods that have external costs.

It raises money for the government, which can be spent on services such as healthcare.

❌ Disadvantages

If demand is inelastic, quantity falls only a little, so the tax may not reduce consumption much.

It may hit low-income households hardest, because they pay the higher price too.

Producers sell less, so profits may fall and some may cut output or jobs.

It is hard to set the tax at the right level.

Subsidy: the diagram

A government may give a subsidy to producers of a merit good, or a good with external benefits, to increase how much of it is bought. Here is a made-up market for eye tests in the country of Tenmar. The government pays a subsidy of $20 per test.

Price per test ($)	Quantity demanded (thousand tests)	Quantity supplied before subsidy, S (thousand tests)	Quantity supplied after subsidy, S₁ (thousand tests)
10	80	20	40
20	70	30	50
30	60	40	60
40	50	50	70
50	40	60	80

The subsidy lowers costs by $20 per test, so at each price firms supply what they used to supply at a price $20 higher.

Worked example

Before the subsidy, demand equals supply at $40, so the equilibrium price is $40 and the equilibrium quantity is 50 thousand tests.

After the subsidy, demand equals supply at $30, so the new equilibrium price is $30 and the new equilibrium quantity is 60 thousand tests.

The price falls by $10 and the quantity rises by 10 thousand tests.

The government pays $20 on each test supplied: 60,000 × $20 = $1.2 million.

Draw the same axes, with D, S, P₁ and Q₁ as before.
Draw a new supply curve S₁ to the right of S. It is also lower, because costs have fallen. The vertical gap between S and S₁ is the amount of the subsidy.
Mark where D meets S₁. Label the new price P₂ and quantity Q₂.
P₂ is lower than P₁ and Q₂ is higher than Q₁.

Advantages and disadvantages of subsidies

✅ Advantages

The lower price and higher quantity raise consumption of merit goods.

Goods such as healthcare and education become more affordable for low-income households.

Producers' costs fall, which can help firms stay in business and keep their workers.

❌ Disadvantages

It costs the government money, which comes from taxpayers and has an opportunity cost, because the money could be spent elsewhere.

It is hard to know how large the subsidy should be.

Firms may rely on it and have less reason to cut their own costs.

It can be hard to take away once people expect it.

Common mistakes

Shifting the supply curve the wrong way. A tax shifts S to the left (up). A subsidy shifts S to the right (down).
Shifting the demand curve instead of the supply curve. Both tools change the cost of supplying, so it is the supply curve that moves.
Forgetting to label the new equilibrium, or the old one. Show P₁, Q₁, P₂ and Q₂.
Saying a tax always works. If demand is inelastic, the quantity falls only a little.

Exam-style question

The government of the made-up country of Belmora wants to cut the use of disposable plastic bags. It is considering an indirect tax on each bag. It also thinks about giving a subsidy to firms that make reusable cloth bags.

(a) Define "indirect tax". [2 marks]

(b) Explain how an indirect tax on plastic bags could reduce their consumption. [4 marks]

Model answer

(a) An indirect tax is a tax on spending on a good or service (1). The seller collects it and passes it to the government, so it adds to the cost of supply (1).

(b) The tax raises the cost of supplying each bag (1), so the supply curve shifts to the left (1). The equilibrium price rises (1) and the quantity bought falls, so consumption is reduced (1).

(c) A subsidy lowers the cost of reusable bags (1), so their price falls and more are bought (1). This may replace some plastic bags, and the subsidy does not make shoppers pay more (1). However, it costs the government money, which has an opportunity cost (1). A tax on plastic bags raises revenue, but if demand is inelastic, shoppers may keep buying plastic bags (1). Using both together may work best. A subsidy is better than a tax only if people see reusable bags as a good alternative (1).

Exam tip

In part (b), write the full chain: cost rises, supply shifts left, price rises, quantity falls. Each link earns a mark.

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