Indirect taxes

An indirect tax is charged on producers of goods and services and is paid by the consumer indirectly. Examples of indirect taxes include VAT,  excise duties (cigarette, alcohol tax) and import levies.

Example of VAT as an indirect tax

VAT rates may be set at 20%. This percentage tax is known as an advalorem tax – it means the producer is charged a percentage of the price. For example, If the good is priced at £100, the firm has to pay £20 to the government, and this will be partly absorbed by the consumer through higher prices.

Tax-ad-valoremWhen we buy a new tv for £300, the indirect tax is not immediately visible, we only see the final sales price. It is the firm selling the good which is responsible for collecting the tax and paying the government.

Import duties as indirect tax

If the government imposed import duties on goods such as whiskey imports. The supermarket importing the whisky is responsible for paying the import duty on arrival in the country. This import levy  will influence the price that the supermarket charges to the consumer.

The burden of indirect taxes

If the government imposes an indirect tax on a good, the effect on the final price depends on the elasticity of demand. If demand is price inelastic, then the firm will be able to pass on the majority of the tax to the consumer (consumer burden). If the demand is price elastic, then the producer will absorb most of the tax in reduced profit margin (known as producer burden)

tax-depends-elasticityComparison with direct taxes

A direct tax is paid for by the individual the government is aiming to tax. For example, with income tax, workers pay the tax directly to the government. Direct taxes can have a higher political cost because the impact is more pressing to the individual.

Advantages of indirect taxes

  • It is easier for firms to pay indirect taxes than consumers
  • In the US, some sales taxes are direct. This means when a good is bought. The shop adds the indirect tax onto the good. This means consumers see incorrect prices and the final price can be an awkward amount to pay e.g. $4.99 becomes $5.44 after 9% sales tax.
  • Indirect taxes can be used to overcome market failure and make people pay the full social cost. For example, excise duties like cigarette and tobacco tax can internalise the external cost of smoking and drinking alcohol.

Potential disadvantages of indirect taxes

  • Regressive nature of indirect taxes. Indirect taxes tend to take a higher percentage of income from those on low income. For example, a smoker who pays £1,000 a year in smoking duties. For a smoker on low-income (£10,000), this will be a high percentage of income 10%. For someone on high income, £120,000 – this same tax will be much smaller percentage 0.8%
  • Can encourage tax evasion. Cigarette taxes can encourage a black market in bootleg cigarettes.

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