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Indirect taxes are placed on products which the government thinks are either bad for the economy or are a good way of raising money! Cigarettes fit both reasons: they are undoubtedly bad for you and cost the nation in terms of unnecessary health care; smokers will generally pay any price to fix their habit! By placing an additional tax on smoking (on top of VAT), the government raises substantial amounts of money to spend on a whole range of services and reduces the number of cigarettes consumed (though if the quantity consumed fell by a large proportion, what would happen to their tax revenues?).

When an indirect tax is placed on a product, the business does not keep all of the selling price e.g. if a 10% tax is placed on a good sold for £1, the business keeps 90p and gives 10p to the government. An indirect tax reduces the profit margin and businesses will look for other goods to sell, reducing the supply of the good.

What does an indirect tax do to the supply curve in a supply and demand diagram? It shifts the supply curve to the left because at every price each business in the market will want to produce less of the product:

The effect of an indirect tax is to reduce the quantity consumed and increase the market price. Click on the diagram above to look at a business problem. Make sure you’ve looked at the subsidy page before you do this.