Indirect tax

An indirect tax is a type of levy placed on goods and services. This tax is applied before the product reaches the final customer. The customer eventually pays the tax as part of the market price. This system is different from a direct tax. A direct tax is collected straight from a person or a company. In contrast, an indirect tax is collected by an intermediary, like a retail store. The store collects the money from the buyer and later sends it to the government.

The mechanism of an indirect tax relies on the ability to shift the tax incidence. The tax incidence refers to who actually bears the economic burden of the tax. If the entity paying the tax to the government does not suffer a loss in income, the tax has been shifted. This shifting can be intentional or unintentional. For example, a firm might raise prices to cover a new tax. This shifts the burden to the consumer. The final outcome often depends on price elasticity of demand (PED) and price elasticity of supply (PES). If demand is inelastic, consumers usually pay more of the tax. If supply is inelastic, producers might bear more of the burden.

There are several distinct types of indirect taxes used by governments. A sales tax is paid by the customer at the moment of purchase. A value-added tax, or VAT, is a multistage tax. It is collected in parts at every stage of production and distribution. Each entity pays a portion based on the value they add to the product. Another type is the excise tax. These are often used to reduce the consumption of specific goods. For instance, taxes on cigarettes or alcohol are common excise taxes. Governments also use tariffs, which are taxes on imports.

History shows how these systems have evolved over time. The concept of the value-added tax was the brainchild of a German industrialist. His name was Dr. Wilhelm von Siemens, and he proposed it in 1918. He wanted a system that was efficient and simple to enforce. A century later, VAT and the goods and services tax (GST) are very common. They are now used in over 140 countries globally. In many developing countries, governments rely heavily on trade taxes. These are collected at ports of entry because they are easier to manage. As trade liberalization increases, these countries are moving toward domestic consumption taxes like VAT.

Indirect taxes play a major role in national budgets. Data from the OECD shows their significant impact on total revenue. In 2018, the average share of indirect tax for OECD member countries was 32.7%. The standard deviation for this figure was 7.9%. Different countries use these taxes at very different rates. Chile had the highest share of indirect tax at 53.2%. On the other end, the USA had a share of 17.6%.

These taxes can serve specific social and economic purposes. Tariffs are used to protect domestic producers from foreign competition. By making imports more expensive, local businesses can stay competitive. Excise taxes are used to correct market failures. These failures occur when a product creates a negative externality. A negative externality is a harmful side effect, like second-hand smoke from cigarettes. By increasing the price through an excise tax, the government reduces consumption. This can improve public health and reduce the need for other taxes.

However, indirect taxes can also create economic challenges. They often have a regressive effect on income distribution. A regressive tax is one that takes a larger percentage of income from low-income earners. This happens because everyone pays the same tax regardless of their wealth. For example, a $100 tax is only 1% of a $10,000 income. But that same $100 is 2% of a $5,000 income. Because of this, indirect taxes do not act as automatic stabilizers. They do not automatically adjust to help the economy during different economic conditions. This makes the design of the tax system very important for fairness.