IB Economics 2.7.3: Indirect Taxes & Subsidies Explained with Diagrams

Overview

The lesson compares indirect taxes and subsidies as ways governments influence markets. Unlike price controls, which directly set a permitted price, these policies change producers’ costs and incentives. This shifts the supply curve and affects prices, output, stakeholders, and resource allocation.

Indirect Taxes

An indirect tax is charged on spending on goods or services. Consumers pay it when buying from firms, which then pass the tax revenue to the government. This differs from a direct tax, such as income tax, which a person pays directly to the government.

The lesson distinguishes between:

• Excise taxes: Usually taxes on particular goods.
• Sales taxes, including value-added tax (VAT): Taxes applied more broadly to sales.

The focus is on specific excise taxes, which are a fixed amount per unit. An ad valorem tax, by contrast, is a fixed percentage of a good’s price.

Excise taxes are often applied to products such as fuel, cigarettes, and alcohol. Governments may use them to discourage consumption and production, raise revenue, or tax luxury goods as a way to redistribute income.

Market Diagram and Effects

1. Begin with the original equilibrium price and quantity, (P^) and (Q^).
2. A specific tax increases firms’ costs, shifting supply upward/leftward by the amount of the tax. The demand curve does not shift.
3. The new equilibrium has:
   • A higher price paid by consumers, (P_C).
   • A lower quantity bought and sold, (Q_T).
   • A lower net price received by producers, (P_P), after they remit the tax.
4. The vertical gap between (P_C) and (P_P) is the tax per unit.
5. Government tax revenue is the tax per unit multiplied by the quantity sold after the tax. It is represented by the rectangle between (P_C) and (P_P) at (Q_T).

Stakeholders and Welfare

• Consumers lose: They pay more and buy less.
• Producers lose: They receive less per unit and sell fewer units, reducing revenue.
• Workers may lose: Lower production can reduce demand for labor and potentially increase unemployment.
• Government gains: It receives tax revenue.
• Society may lose overall: Output falls below the original equilibrium quantity, creating an underallocation of resources and a deadweight welfare loss. Consumer and producer surplus shrink. The tax revenue is not itself deadweight loss because it becomes government revenue.

When measuring post-tax producer surplus, use the original supply curve, not the shifted, tax-inclusive supply curve.

Subsidies

A subsidy is a government payment intended to encourage production or consumption. The lesson focuses on fixed, per-unit payments to producers. Subsidies may also take forms such as low-interest loans, tax relief, direct provision of goods, or payments to consumers.

Governments may subsidize goods or industries to support valued sectors, make essentials more affordable, encourage goods such as education or renewable energy, promote vaccination, increase exports, or address allocative inefficiency—for example, by encouraging consumption or production of merit goods. Subsidies require government spending, so they have an opportunity cost.

Market Diagram and Effects

1. Start from the original equilibrium, (P^) and (Q^).
2. A per-unit subsidy lowers firms’ costs, shifting supply downward/rightward by the subsidy amount. The demand curve does not shift.
3. The new equilibrium has:
   • A lower price paid by consumers, (P_C).
   • A higher quantity traded, (Q_{\text{sub}}).
   • A higher total price received by producers, (P_P), because the government pays the subsidy on top of the consumer price.
4. The vertical gap between (P_P) and (P_C) is the subsidy per unit.
5. Government expenditure is the per-unit subsidy multiplied by the quantity sold after the subsidy. It is represented by the rectangle between (P_P) and (P_C) at (Q_{\text{sub}}).

Stakeholders and Welfare

• Consumers gain: They pay less and obtain a larger quantity.
• Producers gain: They receive more per unit and sell more, increasing revenue.
• Some workers may gain: Higher production can create additional jobs.
• Government loses financially: Funding the subsidy means less money is available for other priorities; it may require higher taxes or contribute to a budget deficit.
• Society may lose overall: The subsidy can lead to an overallocation of resources and a welfare loss. The government-spending rectangle is an opportunity cost, though some of it is offset by gains in consumer and producer surplus. The remaining deadweight loss is the triangle associated with the additional output.

As with taxes, use the original supply curve when calculating consumer and producer surplus after the subsidy. If a subsidy supports exports, domestic producers may become more competitive, while foreign producers may lose competitiveness.

HL Calculation Methods and Examples

Tax Example

The lesson’s alcohol diagram gives these results:

• Per-unit tax: The vertical gap between the supply curves is $10.
• Quantity sold after tax: 30 units.
• Government revenue: (10 \times 30 = \$300).
• Consumers’ additional tax burden per unit: The price rises from $15 to $20, or $5. Across 30 units, that is $150.
• Consumer spending before tax: (15 \times 40 = \$600).
• Consumer spending after tax: (20 \times 30 = \$600). The example therefore shows no change in consumer spending.
• Deadweight loss: The triangle’s area is $50.
• Producer surplus after tax: $200, calculated using the price producers receive after tax and the original supply curve.
• Consumer surplus falls from $400 before the tax to $225 after it.

Subsidy Example

For the medicine diagram:

• Before the subsidy, producers’ revenue is (4.50 \times 700 = \$3{,}150).
• After the subsidy, consumers pay $4, producers receive $5, and output is 800 units. Producer revenue is (5 \times 800 = \$4{,}000), an increase of $850.
• Consumer spending rises from $3,150 to (4 \times 800 = \$3{,}200), an increase of $50.
• Government expenditure is ((5 - 4) \times 800 = \$800).
• The deadweight welfare loss is $50.

Featured Speakers and Sources

One instructor, presenter, or narrator explains the lesson. The subtitles do not name the presenter; the video is attributed to the Kevin Means Business channel. No interviewees, additional speakers, or external sources are identified in the subtitles.