Indirect taxes and subsidies
50 marks: 12 multiple choice questions, a data response and an essay. Answers are at the end.
AQA: Question 14 would be a 25-mark question on your papers.
Edexcel: Question 14 would be a 25-mark question on your papers.
OCR: Question 14 would be a 25-mark question on your papers.
Multiple choice online
The test
1An indirect tax is a tax on:
- A the wealth held by households
- B spending on goods and services, paid to the government by the seller
- C the profits earned by firms
- D the income that households earn from employment, savings and other sources
2A specific tax differs from an ad valorem tax in that a specific tax:
- A is a fixed amount per unit sold, whatever the price
- B is paid by the consumer rather than the producer
- C is a percentage of the selling price, so the amount of tax rises when the price rises
- D cannot be passed on to consumers
3An ad valorem tax shifts the supply curve:
- A upwards by the same amount at every price, so the new curve is parallel to the old one
- B downwards, because sellers receive less per unit
- C upwards by a larger amount at higher prices, so the new curve is steeper than the old one
- D to the right, because sellers must sell more to cover the tax
Before a tax, a bottled drink sells for £2.00 and weekly sales are 50,000 bottles. The government introduces a specific tax of 20p a bottle. The price rises to £2.12 and sales fall to 45,000 bottles a week.
4The share of the weekly tax revenue borne by producers is:
- A £4,000
- B £9,000
- C £5,400
- D £3,600
5The incidence of an indirect tax falls mainly on consumers when:
- A the tax is a specific tax rather than an ad valorem tax
- B the government collects the tax from consumers rather than from sellers
- C demand is price inelastic and supply is price elastic
- D demand is price elastic and supply is price inelastic
6A specific tax of £3 a unit is imposed on a good. Sales fall from 9,000 units to 7,000 units a week. Weekly tax revenue is:
- A £21,000
- B £6,000
- C £27,000
- D £24,000
7A per-unit subsidy to producers will lower the market price by the most when:
- A demand is price elastic
- B demand is unit elastic
- C supply is perfectly elastic
- D demand is price inelastic
8The total cost of a per-unit subsidy to the government equals:
- A the fall in price multiplied by the quantity sold after the subsidy
- B the subsidy per unit multiplied by the quantity sold after the subsidy
- C the subsidy per unit multiplied by the quantity that was sold before the subsidy was introduced
- D the rise in quantity multiplied by the subsidy per unit
9A government subsidises rail fares to raise passenger numbers. The subsidy will raise passenger numbers by the most if the demand for rail travel is:
- A price elastic
- B price inelastic
- C unit elastic
- D income inelastic
10Indirect taxes are often described as regressive because:
- A the amount paid rises as income rises
- B they are charged at a lower rate on luxury goods
- C poorer households pay more tax in total than richer households do over a year
- D they take a larger percentage of the income of poorer households than of richer ones
11The welfare (deadweight) loss caused by an indirect tax on a good with no external costs arises because:
- A the tax raises the cost of collecting revenue
- B producers pass the whole tax on to consumers
- C some trades that would have benefited both buyer and seller no longer take place
- D the government spends the revenue on projects that are worth less than the tax collected
12The UK soft drinks industry levy is charged per litre at two rates, depending on how much sugar a drink contains. Its main aim was to:
- A protect UK drinks producers from imports
- B encourage manufacturers to cut the sugar in their drinks
- C raise the price of all soft drinks by the same amount
- D replace VAT on soft drinks
13The soft drinks industry levy was introduced in the UK in April 2018. It was charged at 18p a litre on drinks with 5g to 8g of sugar per 100ml and 24p a litre on drinks with more than 8g. Many manufacturers cut the sugar in their drinks before the levy started, and the sugar content of the drinks covered fell by over 40% between 2015 and 2019. The levy raises about £300 million a year. Table 1 shows the market for one high-sugar drink before and after the levy. Figures are illustrative.
| Before the levy | After the levy | |
|---|---|---|
| Price per litre | £1.10 | £1.28 |
| Sales (million litres a year) | 500 | 440 |
| Levy per litre | 0 | 24p |
(a)Using Table 1, calculate the revenue the levy raises from this drink in a year. [2]
(b)Using Table 1, calculate how much of the levy per litre is passed on to consumers, and explain what this suggests about the price elasticity of demand for the drink. [4]
(c)With the aid of a diagram, explain how the levy affects the market for a high-sugar drink, showing the tax revenue and how it is shared between consumers and producers. [6]
(d)Explain two reasons why the levy may have cut sugar consumption by more than the rise in price alone would suggest. [6]
14Evaluate the view that indirect taxes are an effective way to reduce the consumption of demerit goods such as sugary drinks and alcohol. [20]
Answers
Show the answers
AO1 knowledge, AO2 application, AO3 analysis, AO4 evaluation.
| Answer | Why | |
|---|---|---|
| 1 | B | Indirect taxes such as VAT and excise duties are levied on expenditure and collected from the seller, who may pass some or all of the tax on in the price. |
| 2 | A | Fuel duty is a specific tax (pence per litre); VAT is ad valorem (a percentage of price). |
| 3 | C | A percentage tax adds more in money terms when the price is higher, so the gap between the two supply curves widens as price rises. |
| 4 | D | Consumers pay 12p more a bottle and producers receive 8p less (£2.12 − £0.20 = £1.92). The producers' share is 8p × 45,000 = £3,600; the consumers' share is £5,400; total revenue £9,000. |
| 5 | C | The less responsive side of the market bears more of the tax; who hands the money to the government makes no difference to the incidence. |
| 6 | A | Revenue is the tax per unit multiplied by the quantity sold after the tax: £3 × 7,000 = £21,000. |
| 7 | D | The subsidy shifts supply to the right; with inelastic demand the quantity barely changes, so most of the subsidy shows up as a lower price. |
| 8 | B | Every unit sold after the subsidy attracts the payment, so the bill is the full new quantity times the subsidy per unit. |
| 9 | A | With elastic demand, the fall in fares brings a more than proportionate rise in journeys. |
| 10 | D | A flat tax on a good is the same in money terms for everyone, so it is a bigger share of a low income. |
| 11 | C | Output falls below the free-market level, so units valued above their resource cost are no longer made or bought; that lost surplus is the deadweight loss. |
| 12 | B | A tiered rate gives firms a reason to reformulate below the thresholds, which many did before the levy even started. |
13 (a) Using Table 1, calculate the revenue the levy raises from this drink in a year. [2: AO2 2]
- AO2 (1) 440 million × £0.24
- AO2 (1) £105.6 million
13 (b) Using Table 1, calculate how much of the levy per litre is passed on to consumers, and explain what this suggests about the price elasticity of demand for the drink. [4: AO2 2, AO3 2]
- AO2 (1) Price rose from £1.10 to £1.28, so consumers pay 18p of the 24p levy
- AO2 (1) That is 75% of the levy; producers bear the other 6p (they now receive £1.04 a litre)
- AO3 (1) Most of the tax is passed on, which means the quantity demanded falls only modestly when price rises: demand is relatively price inelastic (compared with supply)
- AO3 (1) The figures confirm it: a 16.4% rise in price cut sales by 12%, a PED of about −0.7
13 (c) With the aid of a diagram, explain how the levy affects the market for a high-sugar drink, showing the tax revenue and how it is shared between consumers and producers. [6: AO1 2, AO2 1, AO3 3]
- AO1 (2) Diagram: supply shifts vertically upwards by the levy per unit (S to S + tax, parallel); price rises from P1 to P2 and quantity falls from Q1 to Q2; the price producers receive, P2 minus the tax, marked below P1; the revenue rectangle between the two prices across Q2, split at P1 into the consumers' share (above) and the producers' share (below)
- AO3 (1) The levy is a cost to the seller on every litre, so at each price sellers offer less: supply shifts up by 24p
- AO3 (1) At the new equilibrium the price has risen by less than the levy, because the higher price cuts quantity demanded and sellers absorb part of the tax to keep sales
- AO3 (1) Revenue is the levy times the new quantity; consumers' share is the price rise times Q2, producers' share is the fall in the price they receive times Q2; the lost output Q1 to Q2 is a deadweight loss unless the good has external costs
- AO2 (1) Application: here P1 = £1.10, P2 = £1.28, the producers' price is £1.04, Q2 = 440 million litres; consumers bear 18p of the 24p
Levels: 1 to 2 for a description with a partly correct diagram; 3 to 4 for a correct diagram with the shift and incidence explained; 5 to 6 for the full chain applied to the figures in Table 1.
13 (d) Explain two reasons why the levy may have cut sugar consumption by more than the rise in price alone would suggest. [6: AO1 2, AO2 2, AO3 2]
- AO1+AO2+AO3 (3) Reformulation: because the levy is tiered by sugar content, a manufacturer can avoid it entirely by cutting sugar below 5g per 100ml; many did so before April 2018, so consumers bought less sugar even where price and quantity barely changed (the 40% fall in sugar content)
- AO1+AO2+AO3 (3) Substitution: zero-sugar versions of the same brands carry no levy, so the price gap between the sugary and the sugar-free version widened and some consumers switched without cutting their total drinks purchases
- AO1+AO2+AO3 (3) Or: the information effect of the levy and the publicity around it changed attitudes to sugar, shifting demand left as well as moving along it; or retailers used the levy as an occasion to promote lower-sugar lines
Maximum 6: two reasons, each explained and applied to the levy.
14 Evaluate the view that indirect taxes are an effective way to reduce the consumption of demerit goods such as sugary drinks and alcohol. [20: AO1 6, AO3 6, AO4 8]
Knowledge and analysis (AO1 to AO3)
- Define an indirect tax and a demerit good (over-consumed because consumers under-estimate the private costs, or because consumption imposes external costs on others, so the market produces beyond the socially optimal output).
- How the tax works: supply shifts up by the tax, price rises, quantity demanded falls towards the socially optimal level; show on a diagram with the tax set equal to the external cost (or the marginal external cost curve) so that the price reflects the full cost to society. The tax internalises the externality and raises revenue that can fund treatment or information campaigns.
- Incidence and elasticity: demerit goods such as alcohol and tobacco tend to have price inelastic demand, so a tax raises much revenue but cuts consumption little; sugary drinks appear more elastic, especially where close substitutes (zero-sugar versions) exist, so the levy cut sugar more effectively. Evidence: UK tobacco duty has raised prices steadily while smoking has fallen, but it is hard to separate the tax from other policies; the sugar levy cut sugar content by over 40% largely through reformulation.
- Design matters: a tiered or targeted tax (the sugar levy's thresholds, minimum unit pricing in Scotland and Wales for alcohol) changes producer behaviour as well as consumer behaviour; a flat tax on all drinks would not.
- Problems: regressive, taking a larger share of low incomes (though the health benefits also fall mainly on low-income groups); unintended consequences such as cross-border shopping, illicit markets for tobacco and alcohol, or substitution to untaxed products that are just as harmful; the tax raises prices for moderate consumers who impose no external cost; the correct size of the tax is hard to set because the external cost is hard to measure.
- Alternatives: regulation (age limits, advertising bans, plain packaging, minimum unit pricing), information and education, subsidies for healthier substitutes, or outright bans; each has its own costs and enforcement problems.
Evaluation (AO4)
- It depends on the price elasticity of demand: effective at changing behaviour where demand is elastic (sugary drinks with substitutes), mainly a revenue raiser where it is inelastic (tobacco, alcohol for heavy users).
- It depends on the design: tiered taxes that reward reformulation work on the producer side as well as the consumer side.
- It depends on the time horizon: demand becomes more elastic in the long run as habits and products change, so the effect grows.
- Effective for what: as a revenue source indirect taxes on demerit goods are very effective; as a way of changing the behaviour of the heaviest consumers, who cause most of the external cost, they are weakest.
- The distributional cost may be judged acceptable if the revenue is used to help the groups who pay most, or if the health gains to those groups are large.
- No single policy is enough: the UK's falls in smoking came from taxes, bans and information together.
Judgement
A supported judgement might conclude that indirect taxes are an effective part of the answer, and the best single tool where demand is responsive and the tax can be designed to change what producers sell, as with the sugar levy; but where demand is inelastic they reduce consumption slowly and fall hardest on low-income consumers, so they work best combined with regulation and information rather than on their own.
Marking
Bands, out of 20 (AO1 knowledge 6, AO3 analysis 6, AO4 evaluation 8, as WJEC marks a 20-mark question). Top band (16 to 20): a range of points developed in full chains of reasoning, supported by an accurate diagram and real examples, with evaluation that weighs the arguments and reaches a judgement that depends on stated conditions. Middle band (9 to 15): some developed chains, a relevant diagram, evaluation present but one-sided or asserted. Bottom band (1 to 8): points listed or described, little use of theory or examples, judgement missing or unsupported.