Indirect taxes and their incidence

The impact of an indirect tax

An indirect tax is a tax on expenditure, collected from producers, who try to pass it on in higher prices. It may be specific (a fixed amount per unit) or ad valorem (a percentage of price).

Diagram in words (specific tax): D and S1 cross at P1, Q1. The tax shifts supply vertically up by the tax to S2 (= S1 + tax). The new equilibrium is where S2 crosses D: consumers pay a higher price Pc, quantity falls to Q2. Producers keep Pc minus the tax, a lower price Pp, found by going down from the S2 point to S1 at Q2.

• Consumers: pay more (Pc higher than P1) and buy less; consumer surplus falls.
• Producers: receive less per unit (Pp lower than P1) and sell less; producer surplus falls.
• Government: gains revenue = tax per unit x Q2, the rectangle between Pc and Pp out to Q2.
• Deadweight (welfare) loss: the triangle between D and S1 from Q2 to Q1, the surplus lost and not collected as tax.

Incidence of the tax

Incidence means who actually bears the burden.

• Consumer incidence per unit = Pc - P1. Total = (Pc - P1) x Q2: the part of the tax rectangle above the old price.
• Producer incidence per unit = P1 - Pp. Total = (P1 - Pp) x Q2: the part below the old price.

The more price inelastic demand is (relative to supply), the larger the consumer share: consumers keep buying, so firms can pass on most of the tax. If demand is elastic, firms must absorb most of it. Similarly, inelastic supply puts more burden on producers.

Evaluate: incidence also matters for equity. Taxes on goods that take a larger share of poorer households' income (such as tobacco or fuel) are regressive.

Real example: the UK sugar tax

The UK's Soft Drinks Industry Levy came into effect on 6 April 2018, charging producers 24p per litre on drinks with 8 grams or more of sugar per 100ml and 18p per litre on drinks with 5 to 8 grams (GOV.UK, 2018). The government reported that over 50% of manufacturers had reduced the sugar in their drinks after the levy was announced in March 2016, and expected revenue fell from an original £520m to £240m a year. The rates were raised for the first time from 1 April 2025, to 19.4p and 25.9p per litre, and official statistics recorded receipts of £327 million (provisional) in 2024 to 2025 (GOV.UK, January 2026).

This shows producers changing what they supply to avoid the tax, which reduces the tax base. A tax designed to change behaviour can succeed even if it raises less revenue than first planned.

Worked example

Demand is Qd = 120 - 4P and supply Qs = -20 + 3P (equilibrium P = 20, Q = 40). A specific tax of $7 per unit is imposed. Find the consumer and producer incidence, the tax revenue and the deadweight loss.

1. New supply: Qs = -20 + 3(P - 7). Set equal to demand: P = 23 (consumers' price), Q = 28.
2. Producers keep 23 - 7 = 16.
3. Consumer incidence = 23 - 20 = $3 per unit; producer incidence = 20 - 16 = $4 per unit.
4. Revenue = 7 x 28 = $196 (consumers pay 84, producers 112).
5. Deadweight loss = 1/2 x 7 x (40 - 28) = $42.

Answer: Consumers bear $3 and producers $4 of each $7; revenue $196; deadweight loss $42.

Check yourself

1. In the lesson's market, what share of the total tax revenue is paid by consumers? Give a percentage to 1 decimal place.
   Show answer

   42.9 %. Consumer share = 3 / 7 x 100 = 42.9%.

2. Before a $2 tax, the price was $10. After the tax, consumers pay $11.50. How much of each $2 is paid by producers?
   Show answer

   $0.50. Consumers pay 11.50 - 10 = $1.50, so producers pay 2 - 1.50 = $0.50 per unit.

3. After a $1.20 per unit tax, 25,000 units are sold. Calculate government tax revenue.
   Show answer

   $30000. 1.20 x 25,000 = $30,000.

4. Repeat the lesson's $7 tax with a much more inelastic demand curve, Qd = 60 - P, and the same supply. What percentage of the tax do consumers now pay?
   Show answer

   75.0 %. Before tax P = 20; after tax consumers pay 25.25; consumer share = 5.25 / 7 x 100 = 75%, higher than 42.9% before.

5. The burden of an indirect tax falls mainly on consumers when
   • demand is price elastic
   • supply is perfectly inelastic
   • demand is price inelastic
   • the tax is very small
   Show answer

   demand is price inelastic. Consumers keep buying, so producers can pass on most of the tax.

6. On an indirect tax diagram, the deadweight loss is the
   • triangle between demand and the original supply curve, from the new quantity to the old quantity
   • rectangle of tax revenue
   • area of consumer surplus after the tax
   • vertical distance between the supply curves
   Show answer

   triangle between demand and the original supply curve, from the new quantity to the old quantity. It is surplus lost from trades that no longer happen and is not collected as tax.

7. Under the UK Soft Drinks Industry Levy introduced in 2018, what was the rate for drinks with 8 grams or more of sugar per 100ml?
   • 18p per litre
   • 20% of the price
   • 24p per litre
   • 8p per can
   Show answer

   24p per litre. GOV.UK (2018): 24p per litre for 8g or more, 18p per litre for 5 to 8g.

8. Explain the effect of an indirect tax on producers.
   Show answer

   The tax raises producers' costs, so supply shifts left (upwards by the tax). Producers receive a lower price per unit after paying the tax and sell a smaller quantity, so their revenue and producer surplus fall.. Shift, then price received, then quantity and surplus.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (2018)
• GOV.UK news story: Soft Drinks Industry Levy comes into effect (2018)
• GOV.UK: Soft Drinks Industry Levy statistics commentary (published 30 January 2026)

Last updated 8 November 2026. Spotted a mistake? Tell us.