Indirect Tax
An indirect tax is a tax levied on goods and services rather than on income or profits. Value added tax, sales tax, excise duties, customs duties, and specific levies on alcohol, tobacco, and fuel are examples. Indirect taxes are collected by businesses and passed on to the government, and they are ultimately borne by consumers, producers, or both, depending on the elasticities of supply and demand. They are a major source of revenue in most countries and an instrument of policy toward consumption and behaviour.
Types
Value added tax is levied on the value added at each stage of production and distribution, with businesses recovering the tax paid on their inputs. It is a broad-based tax on consumption and is used in most countries outside the United States. A retail sales tax is levied only at the final sale to the consumer, and it requires no mechanism for recovering tax on inputs, but it is more vulnerable to evasion at the retail stage.
Excise duties are levied on specific goods, often those with inelastic demand or with external costs, such as alcohol, tobacco, and fuel. Customs duties are levied on imports and are a form of indirect tax as well as an instrument of trade policy. Specific taxes are levied as a fixed amount per unit, while ad valorem taxes are levied as a percentage of value, and the choice affects how the burden changes with price.
Incidence
The incidence of an indirect tax, that is, who ultimately bears its cost, depends on the relative elasticities of supply and demand. If demand is inelastic and supply is elastic, consumers bear most of the tax through higher prices. If demand is elastic and supply is inelastic, producers bear most of it through lower prices received. The legal obligation to remit the tax does not determine the economic incidence, a point that is central to the analysis of tax policy.
The incidence also depends on the structure of the market. In competitive markets, the tax raises the price and reduces the quantity traded, and the burden is shared according to the elasticities. In imperfectly competitive markets, the response may differ, and firms may absorb more or less of the tax depending on their pricing power. The long-run effects may differ from the short-run effects, because in the long run firms can adjust capacity and exit or enter the market.
Efficiency and equity
Indirect taxes distort behaviour by changing the relative prices of goods. The distortion creates deadweight loss, which is larger when demand and supply are more elastic. The efficiency cost can be minimised by taxing goods with inelastic demand and by spreading taxes broadly rather than concentrating them on a few goods, although distributional considerations may argue for a different structure. The analysis of optimal taxation balances efficiency against equity.
Distributional concerns are central. Indirect taxes are often regressive in their effect on household budgets, because lower-income households spend a larger share of their income on consumption, so that a uniform consumption tax takes a larger fraction of their income than of higher-income households. Exemptions and reduced rates for necessities, such as food and medicine, can reduce the regressive impact, but they also narrow the base and raise the rates needed for a given revenue, and they can be poorly targeted compared with direct transfers.
Use and administration
Indirect taxes are used for revenue, for the correction of externalities, and for the discouragement of consumption deemed harmful. Excise duties on alcohol and tobacco raise revenue and, by raising the price, reduce consumption, which is justified when the consumption imposes costs on others or on the consumer. Environmental taxes on carbon and on pollution are indirect taxes that address externalities and raise revenue, and they are increasingly used as instruments of climate policy.
Administration requires mechanisms for collection at the point of sale and for auditing compliance. Value added tax systems require businesses to register, to charge tax on sales, and to claim credit for tax paid on inputs, which requires record-keeping and creates incentives for fraud, including the use of fictitious invoices. Measures to counter fraud, such as reverse charging and digital reporting, are important for protecting revenue, and compliance costs for businesses are a consideration in the design of the tax.
VAT versus retail sales tax
The choice between a value added tax and a retail sales tax has practical consequences. A value added tax is collected at each stage of production and distribution, with businesses claiming credit for the tax paid on their inputs, so the tax is neutral with respect to the number of stages and the structure of production. A retail sales tax is collected only at the final sale, which requires an effective system for identifying final sales and creates an incentive for businesses to misclassify purchases as inputs.
The value added tax is generally more robust to evasion because the credit mechanism creates a paper trail and because each business has an incentive to obtain invoices for its purchases. However, it imposes higher compliance costs on businesses, which must register, keep records, and file returns, and it requires a sufficiently large formal sector. The retail sales tax is simpler for businesses but more vulnerable to evasion and to the growth of untaxed online sales.
Taxation and behaviour
Indirect taxes change behaviour as well as raising revenue. Taxes on tobacco and alcohol reduce consumption, and the evidence shows that higher prices reduce both initiation and consumption, particularly among young people. Carbon taxes raise the price of fossil fuels and encourage substitution toward cleaner energy and greater efficiency, though the response depends on the availability of alternatives and on the design of complementary policies.
The behavioural response determines both the revenue and the welfare cost. Where demand is elastic, a tax raises little revenue and distorts behaviour substantially, while where demand is inelastic, it raises more revenue with less distortion but may be regressive and may have little effect on behaviour. The design of environmental and health taxes must therefore balance the objective of changing behaviour against the objectives of revenue and distribution, and the revenues can be used to reduce other taxes or to fund compensation.
International aspects
Indirect taxes interact with international trade. Under the destination principle, goods are taxed in the country of consumption, with exports exempt and imports taxed, which requires border adjustments and can create incentives for fraud, including the under-reporting of imports. Differences in rates across countries create incentives for cross-border shopping and for the diversion of goods, and they complicate the taxation of digital services and of e-commerce, which are difficult to locate.
International cooperation and the adoption of common rules, such as those governing value added tax within regional groupings, reduce these problems. Digital reporting, the collection of tax by online platforms, and the use of place-of-consumption rules for services are among the responses. The taxation of consumption in an integrated world economy therefore requires coordination as well as domestic design, and the balance between national autonomy and international consistency is a continuing policy issue.