3.2 Methods and Effects of Government Intervention in Markets | AS Level Economics

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3.2.1 Impact and incidence of specific indirect taxes

Definition: Indirect taxes are taxes on expenditure (e.g. GST, excise duty, customs duty). They are paid by producers to the government but the burden can be shifted to consumers through higher prices. Direct taxes (income tax, corporation tax, inheritance tax) are charged on income or wealth and the burden cannot be shifted.

Impact versus incidence. The impact of a tax is on the person who pays it to the government in the first instance (usually the producer). The incidence is on the person who finally bears the burden. For example, an excise duty on sugar is paid first by sugar manufacturers (impact) but may be passed on to consumers (incidence).

Definition: A specific (unit) tax is a fixed amount of tax per unit sold (e.g. ₹3 per litre of petrol, a tax per 20-pack of cigarettes, a tax on 500 ml sugary drinks). It depends on the quantity sold, not the price.

Consumer burden = (P2 – P1) × Q2. Producer burden = (P1 – (P2 – tax)) × Q2. Tax revenue = tax per unit × Q2 = consumer burden + producer burden.
A deadweight loss arises because the tax reduces quantity below the efficient level: consumer and producer surplus fall by more than the government gains.

Incidence and elasticity

Situation	Who bears more of the tax?	Effect on quantity
Inelastic demand (cigarettes, alcohol, petrol)	Consumers (price rises by nearly the full tax)	Small fall in quantity; large tax revenue
Elastic demand	Producers (they cannot raise price without losing sales)	Large fall in quantity; smaller revenue
Inelastic supply	Producers	Small fall in quantity
Elastic supply	Consumers	Large fall in quantity

Example: A €2 tax on a shirt that retails at €10 with a €5 profit margin: if price rises to €12 the whole burden is on the consumer; if price stays at €10, the producer's margin falls from €5 to €3 and the producer bears everything; if price becomes €11 the burden is shared equally.

Evaluation. Specific taxes raise revenue and can reduce demerit goods and negative externalities. Weaknesses: regressive (low-income households pay a larger share of income), little effect on consumption if demand is inelastic, may lead to smuggling and black markets, and effects depend on elasticity. A specific tax does not change with inflation, so its real value falls over time (an ad valorem tax, a percentage of price, is covered at A Level).

Reasons for taxation include: raising revenue; discouraging demerit goods; reducing income inequality (progressive taxes); funding public and merit goods and transfer payments; managing aggregate demand

and controlling inflation; correcting market failure and negative externalities; protecting domestic firms through tariffs; and correcting a current account deficit.

Figure: Effect of an indirect tax on the market

Figure: Incidence (burden) of an indirect tax

Evaluation (AO3):

Exam tip (official mark scheme): answers that discuss only advantages or only disadvantages of an indirect tax are capped — always cover both sides.

🔒 Also in the full notes

3.2.2 Impact and incidence of subsidies
3.2.3 Direct provision of goods and services
3.2.4 Maximum and minimum prices
3.2.5 Buffer stock schemes
3.2.6 Provision of information
Exam practice: 8 practice questions
3 exemplar answers with full model answers and mark breakdowns

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