An indirect tax is collected by one entity in the supply chain, such as a manufacturer or retailer, and paid to the government. However, the tax is passed onto the consumer by the manufacturer or retailer as part of the purchase price of a good or service. The consumer ultimately pays the tax by paying more for the product.
How an Indirect Tax Works
In contrast to direct taxes, indirect taxes are levied on an individual or entity but are ultimately paid for by another person. The business entity that collects the tax remits it to the government. With direct taxes, the person immediately paying the tax is the person that the government intends to tax.
Excise duties on fuel, liquor, and cigarettes are examples of indirect taxes. By comparison, income tax is the clearest example of a direct tax, as it is paid directly by the person earning the income. Admission fees to national parks also serve as a direct tax example.
Note
Some indirect taxes, such as a value-added tax (VAT), are also known as consumption taxes.
Regressive Nature of an Indirect Tax
Governments commonly impose indirect taxes to generate revenue. These taxes fall equally on all taxpayers, regardless of their income; therefore, everyone—rich or poor—must pay them.
However, many consider indirect taxes to be regressive because they disproportionately impact low-income individuals, who end up paying the same amount of tax as those with higher incomes.
For instance, the import duty on a television from Japan remains the same regardless of the buyer’s income. Thus, someone earning $25,000 a year pays the same duty on the same television as someone earning $150,000.
There is also concern that indirect taxes can serve specific government policies by selectively taxing certain industries.
Note
Some economists argue that indirect taxes create market inefficiencies and push market prices away from their equilibrium.
Common Indirect Taxes
Among the most prevalent examples of indirect taxes are import duties. These duties are paid by the importer when the goods enter the country. If the importer resells the goods to consumers, the duty cost is embedded in the price the consumer pays—an often overlooked form of indirect taxation.
Essentially, any governmental tax imposed during manufacturing or production is an indirect tax. In recent years, many countries have levied carbon emission fees on manufacturers—indirect taxes later borne by consumers.
Sales taxes may be either direct or indirect. They are classified as direct if imposed solely on the final supply to consumers. Conversely, when implemented as VATs throughout the production process, they are classified as indirect taxes.
What Are Indirect Taxes in the U.S.?
Examples of indirect taxes in the United States include those like sales taxes collected by businesses and remitted to the government. Import taxes on foreign goods also fall into this category. Notably, the U.S. does not have a national sales tax.
How Do Businesses Offset the Cost of Taxes?
To recoup tax-funded losses, businesses may increase the purchase price of their goods, which includes the impact of sales tax.
What Are Value-Added Taxes (VATs)?
Value-added taxes (VATs) are assessed throughout the production stages of a product but are non-deductible when paid by consumers, making it an indirect tax on the final price.
The Bottom Line
Indirect taxes are prevalent costs levied on goods and services, paid by the consumer through increased product prices. Unlike direct taxes, these uniform costs impact all consumers equally, regardless of their income.
Related Terms: Sales Tax, Value-Added Tax, Excise Duty, Import Duties, Consumption Tax.
References
- Georgia State University, Andrew Young School of Policy Studies. “Direct Versus Indirect Taxation: Trends, Theory and Economic Significance”, Pages 1-2.
- European Parliament. “Indirect Taxation”.
- Institute of Economic Affairs. “Aggressively Regressive: The ‘Sin Taxes’ That Make the Poor Poorer”, Pages 8-9.
- U.S. Customs and Border Protection. “Customs Duty Information”.
- Gillingham, Robert. Poverty and Social Impact Analysis by the IMF, International Monetary Fund, 2008, pp. 34-53.
- The University of Edinburgh. “Tax Team”.
- Congressional Research Service. “Attaching a Price to Greenhouse Gas Emissions With a Carbon Tax or Emissions Fee: Considerations and Potential Impacts”, Pages 1-10.
- Tax Foundation. “Value Added Tax (VAT)”.
