Indirect Tax

What Is an Indirect Tax?

An indirect tax is collected by one entity in the supply chain (usually a producer or retailer) and paid to the government, but it is passed on to the consumer as part of the purchase price of a good or service. The consumer is ultimately paying the tax by paying more for the product.

Understanding an Indirect Tax

Indirect taxes are defined by contrasting them with direct taxes. Indirect taxes can be defined as taxation on an individual or entity, which is ultimately paid for by another person. The body that collects the tax will then remit it to the government. But in the case of direct taxes, the person immediately paying the tax is the person that the government is seeking to tax.

Excise duties on fuel, liquor, and cigarettes are all considered examples of indirect taxes. By contrast, income tax is the clearest example of a direct tax, since the person earning the income is the one immediately paying the tax. Admission fees to a national park are another clear example of direct taxation.

Some indirect taxes are also referred to as consumption taxes, such as a value-added tax (VAT).  

Regressive Nature of an Indirect Tax

Indirect taxes are commonly used and imposed by the government in order to generate revenue. They are essentially fees that are levied equally upon taxpayers, no matter their income, so rich or poor, everyone has to pay them.

But many consider them to be regressive taxes as they can bear a heavy burden on people with lower incomes who end up paying the same amount of tax as those who make a higher income.

For example, the import duty on a television from Japan will be the same amount, no matter the income of the consumer purchasing the television. And because this levy has nothing to do with a person's income, that means someone who earns $25,000 a year will have to pay the same duty on the same television as someone who earns $150,000; clearly, a bigger burden on the former. 

There are also concerns that indirect taxes can be used to further a particular government policy by taxing certain industries and not others. For this reason, some economists argue that indirect taxes lead to an inefficient marketplace and alter market prices from their equilibrium price.

Common Indirect Taxes

The most common example of an indirect tax is import duties. The duty is paid by the importer of a good at the time it enters the country. If the importer goes on to resell the good to a consumer, the cost of the duty, in effect, is hidden in the price that the consumer pays. The consumer is likely to be unaware of this, but they will nonetheless be indirectly paying the import duty.

Essentially, any taxes or fees imposed by the government at the manufacturing or production level is an indirect tax. In recent years, many countries have imposed fees on carbon emissions to manufacturers. These are indirect taxes since their costs are passed along to consumers.

Sales taxes can be direct or indirect. If they are imposed only on the final supply to a consumer, they are direct. If they are imposed as value-added taxes (VATs) along the production process, then they are indirect.