Indirect tax

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Indirect tax is a levy collected by intermediaries from the final consumer but remitted to the government by someone else—typically a seller or manufacturer (Musgrave R.A., Musgrave P.B. 1989, p.278)[1]. When you buy a $10 coffee and pay $10.88 with sales tax, you don't write a check to the government. The café collects that $0.88 and sends it along. The tax passes through hands before reaching the treasury.

This indirection has consequences. Consumers barely notice taxes embedded in prices. Businesses bear collection costs. And the economic burden falls differently than legal liability suggests. Who really pays? That question—tax incidence—gets complicated fast.

Types of indirect taxes

Several major categories exist:

Sales tax. Applied at point of sale to final consumers. Rate varies by jurisdiction—from zero in some U.S. states to 25% in Scandinavian countries. Simple to understand, collected at one stage.

Value-added tax (VAT). Applied at each production and distribution stage, but only on value added at that stage. A manufacturer buys raw materials (paying VAT), adds value, and charges VAT on the output. Credits for input VAT prevent cascading. Most countries outside the United States use VAT[2].

Excise tax. Targeted levies on specific goods—alcohol, tobacco, fuel, firearms. Often called "sin taxes" when aimed at discouraging consumption. Per-unit ($2.00 per pack of cigarettes) rather than percentage-based.

Customs duties. Taxes on imported goods. Protect domestic industries, generate revenue, sometimes retaliate against trading partners.

Goods and Services Tax (GST). Similar to VAT, used in countries like Canada, Australia, and India. Unifies various indirect taxes into a single system.

How VAT works

Consider a wooden table's journey:

Stage 1: Logger. Sells timber for $100, adding $10 VAT. Pays $10 to government.

Stage 2: Sawmill. Buys timber ($100 + $10 VAT). Processes it and sells lumber for $200, adding $20 VAT. But claims credit for $10 already paid. Remits only $10 to government[3].

Stage 3: Furniture maker. Buys lumber ($200 + $20 VAT). Manufactures table and sells for $400, adding $40 VAT. Claims $20 credit. Remits $20.

Stage 4: Retailer. Buys table ($400 + $40 VAT). Sells to consumer for $500, adding $50 VAT. Claims $40 credit. Remits $10.

Total collected: $10 + $10 + $20 + $10 = $50. Exactly 10% of final price. The mechanism ensures tax applies only to value added at each stage—not to gross transactions.

Why so complex? Because VAT creates an audit trail. Each business has incentive to demand invoices from suppliers (to claim credits). Tax evasion at one stage gets exposed when the next stage seeks credits.

Indirect vs. direct taxes

The fundamental distinction:

Characteristic Direct Tax Indirect Tax
Who pays to government Taxpayer directly Intermediary collects
Legal vs. economic burden Usually aligned Often differs
Examples Income tax, property tax Sales tax, VAT, excise
Visibility Obvious (you file a return) Often hidden in prices
Administration Government collects Businesses collect
Progressivity Often progressive Often regressive

Adam Smith distinguished them by whether burden could be shifted. Direct taxes stick where they land. Indirect taxes can be—and usually are—passed forward to consumers[4].

Tax incidence

Here's the thing: legal liability doesn't determine economic burden. When cigarette tax increases $1 per pack, who actually pays?

If demand is completely inelastic (smokers buy the same amount regardless of price), sellers pass the entire tax to consumers. The $1 appears entirely in prices.

If demand is somewhat elastic, sellers can't fully raise prices without losing sales. They absorb part of the tax in reduced margins. Burden splits between buyers and sellers.

If supply is inelastic (producers can't easily reduce output), producers absorb more of the tax.

The formula for buyer burden depends on relative elasticities:

\[Buyer\\ Share = \frac{E_s}{E_s + E_d}\]

Where E_s is supply elasticity and E_d is demand elasticity[5].

Translation: the more responsive side avoids the tax. Whoever can't easily change behavior bears the burden.

Regressive vs. progressive

Income taxes are typically progressive—higher earners pay higher rates. Indirect taxes tend regressive. Why?

A family earning $30,000 spends nearly all income on taxable consumption. They pay sales tax on almost everything they earn.

A family earning $300,000 saves and invests much of their income. They might spend $150,000 on taxable consumption—half their income.

If both face 8% sales tax on consumption, the poorer family pays 8% of income in sales tax. The richer family pays only 4% of income.

Same rate. Different burden relative to income. That's regressivity[6].

Countries address this through:

  • Exemptions for necessities (food, medicine, children's clothing)
  • Reduced rates for essential goods
  • Rebates for low-income households
  • Higher rates on luxuries

Administrative advantages

Governments like indirect taxes for practical reasons:

Hard to evade. Businesses with registered premises and documented transactions can't easily hide sales. Audit trails exist. Cash-only businesses pose challenges, but formal economy transactions are capturable.

Lower compliance costs. Instead of millions of individual taxpayers filing, thousands of businesses collect and remit. Fewer interactions with government.

Revenue stability. Consumption fluctuates less than income during recessions. VAT revenue holds up better than income tax during downturns.

Collection at source. Imports get taxed at borders. Manufacturers embed taxes in prices. Money flows to government automatically[7].

Economic effects

Indirect taxes create distortions:

Deadweight loss. Taxes raise prices, reducing quantity demanded below efficient levels. The lost consumer and producer surplus exceeds revenue collected. Society loses.

Resource misallocation. Different tax rates on different goods shift consumption patterns. People buy more of lightly taxed goods, less of heavily taxed ones—even when underlying preferences would differ.

Border effects. Differential tax rates between jurisdictions encourage cross-border shopping. New Hampshire's lack of sales tax draws Massachusetts shoppers.

But indirect taxes can also correct market failures:

Pigouvian taxation. Excise taxes on goods with negative externalities (pollution, health costs) make private costs match social costs. Cigarette taxes internalize health care burdens. Carbon taxes address climate change[8].

Demand management. Indirect taxes can cool overheated economies without raising income taxes. Temporary VAT increases reduce consumer spending quickly.

International considerations

Trade complicates indirect taxation:

Origin vs. destination principle. Should taxes apply where goods are produced or consumed? Most countries use destination principle—exports are zero-rated, imports are taxed. This prevents domestic producers from being disadvantaged.

VAT on imports. Countries collect VAT on imports at customs, then allow businesses to claim input credits. This equalizes treatment with domestic production.

Digital services. Traditional rules assumed goods cross borders physically. Digital services don't. Who taxes streaming services consumed in Country A from servers in Country B? Rules are still evolving[9].

Tax competition. Countries may lower indirect tax rates to attract shoppers and businesses. This "race to the bottom" constrains fiscal capacity.

Historical evolution

Indirect taxes predate modern income taxes by centuries:

  • Ancient Rome taxed salt and other commodities
  • Medieval tolls and tariffs funded governments
  • Stamp duties financed wars
  • The Boston Tea Party protested indirect taxation

Income taxes emerged only in the 19th century. For most of history, governments relied primarily on indirect levies—easier to collect in cash-poor agricultural societies.

The 20th century saw income taxes grow dominant in developed countries. But indirect taxes never disappeared. VAT spread from France (1954) across Europe and worldwide. Today, over 160 countries use some form of VAT or GST[10].

Policy debates

Shift from direct to indirect? Some economists advocate replacing income taxes with consumption taxes. Potential benefits: encouraging savings, reducing work disincentives. Concerns: regressivity, transition costs.

Carbon taxation. A major proposed indirect tax—levying costs on carbon emissions. Supporters cite efficiency and environmental benefits. Critics worry about economic impacts and competitiveness.

Digital taxation. How should indirect taxes apply to digital transactions? E-commerce challenges traditional rules. New frameworks are emerging but controversial.

Optimal tax design. What combination of direct and indirect taxes minimizes distortions while raising needed revenue? The answer depends on assumptions about preferences, markets, and administrative capacity[11].


Indirect tax — recommended articles
Fiscal policy — Tax planning — Government expenditure — Economic efficiency

References

Footnotes

  1. ↑ Musgrave R.A., Musgrave P.B. (1989), Public Finance in Theory and Practice, p.278
  2. ↑ OECD (2022), Consumption Tax Trends
  3. ↑ Mankiw N.G. (2020), Principles of Economics, pp.156-172
  4. ↑ Stiglitz J.E. (2000), Economics of the Public Sector, pp.456-478
  5. ↑ Mankiw N.G. (2020), Principles of Economics, pp.178-195
  6. ↑ Musgrave R.A., Musgrave P.B. (1989), Public Finance, pp.312-328
  7. ↑ OECD (2022), Consumption Tax Trends
  8. ↑ Stiglitz J.E. (2000), Economics of the Public Sector, pp.512-534
  9. ↑ Tax Foundation (2023), International Tax Competitiveness Index
  10. ↑ OECD (2022), Consumption Tax Trends
  11. ↑ Stiglitz J.E. (2000), Economics of the Public Sector, pp.567-589

Author: Sławomir Wawak

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