Get started

IB Economics DP HL Revision No

Government
Intervention:
Indirect Taxes &
Subsidies (DP IB
Economics)
Revision Note

Download PDF Test yourself

Written by: Steve Vorster

Reviewed by: Jenna Quinn

Exam board:
DP

Indirect Taxes
An indirect tax is paid on the
consumption of goods/services
It is only paid if consumers make a
purchase
It is usually levied by the
government on demerit goods to
reduce the quantity demanded
(QD) and/or to raise government
revenue
Government revenue is used to
fund government provision of
goods/services e.g education

Indirect taxes are levied by the

government on producers. This is why
the supply curve shifts

An indirect tax can be either ad

valorem or specific

1. A Specific Tax
A specific tax is a fixed tax per unit of
output (specific amount) e.g.
$3.25/packet of cigarettes

The impact of an indirect tax is split

between the consumer (A) and the
producer (B)

Diagram Analysis
Initial equilibrium is at P1Q1
The government places a specific tax
on a demerit good
The supply curve shifts left from
S1→S2 by the amount of the tax

The price the consumer pays has

increased from P1 before the tax, to
P2 after the tax
The price the producer receives has
decreased from P1 before the tax to
P3 after the tax
The government receives tax revenue
= (P2-P3) x Q2
Producers and consumers each pay a
share (incidence) of the tax
The consumer incidence (share)
of the tax is equal to area A: (P2-
P1) x Q2
The producer incidence (share) of
the tax is equal to area B: (P1-P3) x
Q2

New equilibrium is at P2Q2

Final price is higher (P2) and QD is
lower (Q2)
If the decrease in QD is significant
enough, it may force producers to
lay o! some workers

2. Ad Valorem Tax
A tax that is a percentage of the
purchase price e.g. Value added tax
(VAT) in Columbia in 2022 was 19%
The more goods/services
consumed, the larger the tax bill
This causes the second supply
curve to diverge from the original
supply curve
VAT raises significant government
revenue

A diagram showing an ad valorem tax

(VAT) and the tax incidence for producers
and consumers

Diagram Analysis
Initial equilibrium is at P1Q1
The government places an ad
valorem tax to raise government
revenue
Supply shifts left due to the tax
from S → S + tax
The two supply curves
diverge as a percentage tax
means more tax is paid at
higher prices

The price the consumer pays has

increased from P1 before the tax, to P2
after the tax
The price the producer receives has
decreased from P1 before the tax to P3
after the tax
The government receives tax revenue
= (P2-P3) x Q2
Producers and consumers each pay a
share (incidence) of the tax
The consumer incidence (share)
of the tax is equal to area A: (P2-
P1) x Q2
The producer incidence (share) of
the tax is equal to area B: (P1-P3) x
Q2

New equilibrium is at P2Q2

Final price of goods/service is
higher (P2) and QD is lower (Q2)
If the decrease in QD is significant
enough, it may force producers to
lay o! some workers

Examiner Tips and Tricks

When drawing this diagram, students
often find it hard to identify the three price
points.

The tax incidence boxes are formed by

drawing the new equilibrium quantity
through the original supply curve. The
three price points are the old equilibrium
point, the new equilibrium point - and
where the new quantity crosses the
original supply curve.

Irrespective if you are dealing with taxes

or subsidies, always use the new
equilibrium point to determine your
incidence boxes.

The consumer incidence is paid from the

consumer surplus area and the producer
incidence is paid from the producer
surplus area.

Worked Example
Refer to the graph below and answer the
questions that follow.

Answers:

a) The Government imposes a tax of £20

on a product. Calculate the tax revenue
collected by the government [2]

The per unit tax = £20

The quantity traded with the tax is
60,000 units
The total tax revenue gained by the
government = £20 x 60,000 units (1
mark)
= £1,200,000 (2 marks for the
correct answer)

b) Calculate the incidence of tax paid by

the producer [2]

Consumers used to pay £30 for the

product
They pay £40 with the tax - £10 extra
The tax incidence for consumers =
£10 x 60,000 units (1 mark)
= £600,000 (2 marks for the correct
answer)

c) Calculate the change in consumer

spending after the imposition of the tax
[2]

Before the tax, consumers paid £30

for the product and 80,000 units sold
Consumer Expenditure =
£2,400,000
After the tax, consumers paid £40 for
the product and 60,000 units sold
Consumer expenditure =
£2,400,000
There is no change in consumer
expenditure (1 mark + 1 mark for any
correct working)

d) Calculate the deadweight loss caused

by the imposition of the tax [2]

The deadweight loss is the loss of

consumer and producer surplus
It is equivalent to the area of the
triangle that forms between the new
equilibrium quantity and the old
equilibrium quantity

b × h 80 000 − 60 000 × 40 − 20
= = (1
2 2
mark)

20 000 × 20
= = £ 200 000 (1 mark)
2

e) Calculate the producer surplus after

the imposition of the tax [2]

Producer surplus is the area above

the supply curve but under the price
producer receive
Producers receive £20 as the
government receives the balance of
the purchase price of £40 which
represents the tax
The producer surplus can be
calculated by using the formula to
calculate the area of a trapezium

a+ b 20 000 + 60 000
= ×h = × 20
2 2
(1 mark)

= £ 800 000 (1 mark)

An Evaluation of Indirect
Taxes
The Advantages and Disadvantages of
Indirect Taxes

Advantages Disadvantages

Raises the The

price and e!ectiveness
reduces the of the tax in
quantity reducing the
demanded use of demerit
of demerit goods
goods depends on the
Reduces price elasticity
external of demand
costs of (PED)
consumption Many
and consumers
production who
Raises purchase
revenue for products
government that are
programs price
inelastic in
demand
will
continue to
do so

It may help
create illegal
markets as
consumers
seek to avoid
paying the
taxes
Producers may
be forced to lay
o! some
workers as
output falls due
to the higher
prices

A side by side Comparison of

the Impact of PED on Tax
Incidence
Aiming to maximise their profits,
producers pass on as much of the
indirect tax as they can to consumers
and pay the balance themselves
The amount passed on to consumers
depends on the price elasticity of
demand (PED) of the product

A diagram that demonstrates the tax

incidence for a product whose PED is
inelastic (left) and elastic (right). A is the
consumer incidence and B is the
producer incidence

Diagram Analysis
1. In both diagrams
The specific tax shifts the supply
curve from S1→S2
There is a higher market price at
P2 and lower QD at Q2
Tax revenue for the government is
the sum of A+B
Consumer incidence is
represented by A and producer
incidence by B
Total revenue for the seller is
calculated using P3 X Q2
The di!erence in PED results in a
di!erent steepness to the
demand curve

2. For an inelastic product (e.g.

cigarettes)
The curve is steep
Producers pass on a much higher
proportion of the tax to
consumers (A) and pay the rest
themselves (B)
The QD decreases (Q1→Q2) but
by a much smaller proportion
than the increase in price (P1→P2)

3. For an elastic product (e.g. pizza)

The curve is much flatter
Producers pass on a much smaller
proportion of the tax to
consumers (A) and pay the rest
themselves (B)
The QD decreases (Q1→Q2) but
by a much larger proportion than
the increase in price (P1→P2)

Examiner Tips and Tricks

When asked to evaluate the impact of a
tax in a particular market, it is essential to
apply knowledge of PED to the impact it
will have on producers, consumers and
the government.

It should be obvious from the context if

the product in question is elastic or
inelastic in demand. If not, work through
the factors that determine PED and make
a judgement as to whether the product is
elastic or inelastic in demand. In your
answer, explain your reasoning.

Subsidies
A producer subsidy is a per unit
amount of money given to a firm by
the government
To increase production
To increase the provision of a
merit good

The way a subsidy is shared between

producers and consumers is
determined by the price elasticity of
demand (PED) of the product
Producers keep some of the
subsidy and pass the rest on to
the consumers in the form of
lower prices

A diagram which demonstrates the cost

of a subsidy to the government (A+B) and
the share received by the consumer (A)
and producer (B)

Diagram Analysis
The original equilibrium is at P1Q1
The subsidy shifts the supply curve
from S → S + subsidy
This increases the QD in the
market from Q1→Q2
The new market equilibrium is
P2Q2
This is a lower price and higher
QD in the market

Producers receive P2 from the

consumer PLUS the subsidy per unit
from the government
Producer revenue is therefore P3 x
Q2
Producer share of the subsidy is
marked B in the diagram

The subsidy decreases the price that

consumers pay from P1 → P2
Consumer share of the subsidy is
marked A in the diagram

The total cost to the government of

the subsidy is (P3 - P2) x Q2
represented by area A+B

Examiner Tips and Tricks

Memorise the distinction below as
students get very confused when
answering questions on subsidies.

When dealing with

a subsidy, the producer benefit is now
the top portion of the incidence area and
consumer incidence is below. This can be
confusing as in all other diagrams, it is the
other way around (surplus, indirect tax
etc.)

Logically, it makes sense. Producers are

given an extra amount of money for each
unit by the government so this raises
the sales revenue they receive, while at
the same time lowering the price
consumers pay.

Worked Example
The table below contains the demand and
supply schedule for the electric vehicle
market in Luxembourg (prior to any
subsidies)

Price (€ Qd Qs
000s) (000s) (000's)

10 800 200

20 700 300

30 600 400

40 500 500

50 400 600

60 300 700

70 200 800

80 100 900

Answers:

a) The government introduces a subsidy

of €10,000 per vehicle. Draw the supply
and demand graph together with the
new curve which includes the subsidy [3]

(1 mark for accurate labels; 1 mark for

correctly drawn demand and supply
curve; 1 mark for correct shift of supply
curve)

b) Calculate the total cost to the

government of providing the subsidy [2]

550,000 EVs sell with the subsidy (1

mark)
Each EV is subsided at €10,000
The total cost to the government is
€10,000 x 550,000 =
€5,500,000,000 (1 mark)

An Evaluation of Subsidies
The Advantages and Disadvantages of
Producer Subsidies

Advantages Disadvantages

Can be Distorts the

targeted to allocation of
helping resources in
specific markets e.g. it
domestic often results in
industries excess supply
Lowers prices when used in
and increases agricultural
demand for markets
merit goods There is an
Helps to opportunity
change cost
destructive associated
consumer with the
behaviour over government
a longer expenditure -
period of time could the
e.g. money have
subsidising been better