Indirect Tax Definition, Examples, Types, and More [2024]
March 30, 2023
Indirect tax is levied on most, if not all, consumable products. Ultimately, consumers are the ones paying for the amount of indirect taxes added to a product or service.
From household items to imported products like alcohol and tobacco, a significant percentage of indirect taxes are added to the final amount of the product.
In that regard, you automatically pay for this type of tax when you sign up to receive a particular service or purchase goods.
If you’re keen to know more about indirect taxes, read this article and learn how they work and how they affect you as a consumer.
Key Takeaways
- Indirect taxes are taxes levied on goods and services which are then paid for by consumers. The tax rates are added to the selling price of the goods.
- Direct tax rates depend on the taxpayer’s filing status and W-4 form. Indirect taxes remain the same regardless if the taxpayer earns a high or low income.
- Examples of indirect taxes include value-added tax, sales tax, excise tax, and tariff.
- While indirect taxes benefit the economy, their regressive nature leads to an imbalance in market prices and increases the tax burden on low-income taxpayers.
What is Indirect Tax?
An indirect tax, also called consumption tax, is a tax imposed on both the exchange and production of services and goods. It is typically collected by an entity or individual, such as a retailer, supplier, or manufacturer. The retailer or manufacturer collects the tax, and the amount is then added to the purchasing price of the goods.
Ultimately, the imposed indirect tax is forwarded to the consumers for them to pay. In addition, indirect taxes are remitted to the government, which, in turn, uses them to generate revenue to fund state-wide projects.
Some examples of goods and services where consumption tax is levied include:
- Alcoholic beverages
- Basic necessities such as bread and meat
- Clothing
- Coffee
- Jewels and other luxuries
- Motor fuel
- Tobacco
Essentially, it is called an indirect tax because the responsibility of shouldering the tax amount is passed on from the supplier or seller to the consumer or the individual purchasing the goods.
What is the Difference Between Indirect and Direct Taxes?
Direct tax is covered by the individual or entity on whom the tax is imposed, while indirect tax is levied on the manufacturer, supplier, or seller, but it is the buyer who pays for the tax added to the prices of goods.
An example of a direct tax is the income tax. Here, the tax rates are based on the employee’s W-4 Form and filing status and are withheld from their gross salary.
Other examples of direct tax include corporate income taxes and capital gains taxes. Corporate income tax are taxes levied on business revenue by the federal and state governments. Lastly, capital gains taxes are levied on the revenue generated from selling assets.
Meanwhile, indirect tax rates are the same regardless of the net income or tax bracket to which the consumer belongs. It is levied as an added amount to the purchase price of services and goods.
Benefits of Indirect Taxes
Indirect taxes are beneficial because:
#1. They Help the Economy
Indirect taxes help push a nation’s economy in a positive direction. This is especially true in developing countries, where the government can generate more revenue to balance its budget and fund projects that benefit the public.
Since consumption taxes are charged to all consumers, even low-income families can contribute what they can to build their nation’s economy.
#2. They are Easy to Collect
Indirect tax rates are easier to calculate and collect compared to direct taxes. They are added to the final prices of goods, which are then charged to the buyers.
In turn, the seller or supplier collects the indirect tax from consumer payments and remits it to the government.
#3. They aren’t as Obvious
As mentioned above, indirect taxes are combined with the prices of services and goods, which means that consumers generally do not feel or see the presence of taxes on the items they buy.
Consumption taxes are reflected on the receipt, not the price tag, making them easier to overlook.
#4. They Heavily Tax Harmful Products
One of the best solutions to curb the excessive consumption of harmful products such as alcohol and tobacco is to impose higher indirect taxes on these products.
Higher consumption taxes effectively make harmful products more expensive and difficult for the general public to obtain.
Different Types of Indirect Taxes
The following are the most common types of indirect taxes:
#1. Value-Added Tax (VAT)
Value-added tax is a type of tax that is added and evaluated based on the value incorporated at each stage of manufacturing or distributing a product. The tax amount for VAT is spread out from the beginning up to the final stage of producing and retailing goods.
#2. Excise Tax
Excise tax is typically imposed on commodities such as alcohol, fuel, and tobacco. They are also imposed on properties, in which case payment is required directly from the consumers.
#3. Sales Tax
Sales tax is imposed on the sale of services and goods. It is commonly added to the item’s total retail price. The amount of sales tax may also be assessed and adjusted by the state and the local government imposing them.
#4. Tariff
Tariff refers to taxes levied on imported goods. The objective of a tariff is to add to the price of imported products to discourage competition brought by these products against locally and internally produced goods and services.
Indirect Tax Examples
Using some of the different types of indirect taxes enumerated above, here are some concrete examples that exhibit how indirect taxation works:
- The first example involves sales tax. A consumer purchases a dress shirt worth $45. A 7.25% sales tax is imposed on the said item, thereby yielding a purchasing price of $48.26.
- In terms of excise taxes on tobacco, California levies a $2.87 tax, while New York and Connecticut impose a $4.35 tax on cigarettes.
- The US imposes a 25% tariff on all imported, fabricated, and structural steel from China.
- The Japanese government has a 15% tariff on automobiles imported from the US.
What are Some Disadvantages of Indirect Tax?
While indirect taxes are used mainly to help the government generate more revenue for programs and projects that benefit the people, they also come with specific disadvantages, such as:
- Regressive taxation. While indirect taxes are levied equally across all buyers and taxpayers, that doesn’t discount the fact that it also leaves tax burdens that significantly decrease the higher the income that a consumer earns. Consequently, people earning lower incomes will find it more grueling to pay for goods with higher indirect taxes.
- Bias against select industries. The government tends to impose indirect taxes on select industries only. This could potentially raise specific issues, particularly when increased taxes on certain commodities such as alcohol and tobacco encourages the illegal sale of these items.
- Cost-push inflation. Cost-push inflation is the result of the increase in indirect taxes and the costs of raw materials and wages. The prices of goods and services exhibit an upward trajectory, thereby causing an imbalance in how market prices of goods are modified.
Final Thoughts
Indirect taxes are basically everywhere, added to most goods and services that you consume regularly.
Whether it is in the form of excise, sales, or value-added taxes, low, middle, and high-income taxpayers are all charged with these taxes.
Hence, it is important to identify the different types of indirect taxes as well as understand when they are imposed. Doing so helps you see the bigger picture of why the prices of goods fluctuate and how it impacts your expenses in the long run.
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