Indirect tax: Meaning, Criticisms & Real-World Uses

What Is an Indirect Tax?

An indirect tax is a tax levied on goods and services, rather than directly on income or profits, where the burden of the tax can be shifted from the collecting entity to the consumer. In the realm of public finance, indirect taxes are a key component of a government's revenue strategy, falling under the broader category of consumption taxes. Unlike a direct tax, which is paid directly by the individual or entity on whom it is imposed, an indirect tax is collected by an intermediary (such as a manufacturer or retailer) and then passed on to the end consumer through the price of the good or service. This means the consumer ultimately bears the economic burden, even though they do not directly pay the tax to the government.

History and Origin

The concept of indirect taxation, particularly in forms like tariffs and excise taxes, has existed for centuries as a way for governments to generate revenue³⁹, ⁴⁰. However, the modern form of consumption-based indirect taxes, such as the Value-Added Tax (VAT), gained prominence in the 20th century. German industrialist Wilhelm von Siemens first proposed a concept similar to VAT in 1918 to address issues with cascading turnover taxes³⁷, ³⁸.

The modern variation of VAT was first implemented by Maurice Lauré, joint director of the French tax authority, on April 10, 1954, in France's Ivory Coast colony.³⁶ Following its success, France introduced VAT domestically in 1958. The European Economic Community (EEC), now the European Union (EU), further propelled the adoption of VAT by issuing directives in 1967 that provided a blueprint for its introduction across member states, aiming to harmonize trade.³⁵ As of 2025, over 170 countries worldwide utilize a VAT system, with the International Monetary Fund (IMF) strongly advocating for its use.³⁴

Key Takeaways

An indirect tax is levied on goods and services, with the burden typically passed from the seller to the consumer.
Examples include sales tax, Value-Added Tax (VAT), and excise taxes.
These taxes are generally considered regressive, as they take a larger percentage of income from lower-income individuals compared to higher-income individuals.³³
Indirect taxes are a significant source of government revenue globally, and they can also be used to discourage consumption of certain goods (e.g., "sin taxes").³²
Unlike direct taxes like income tax, indirect taxes are not paid directly by the consumer to the taxing authority.

Formula and Calculation

Indirect taxes, particularly sales tax and VAT, are typically calculated as a percentage of the value of the good or service.

Sales Tax Calculation:
Sales tax is a single-stage tax levied on the final retail price of a good or service.

\text{Sales Tax Amount} = \text{Purchase Price} \times \text{Sales Tax Rate}

where:

Purchase Price is the price of the good or service before tax.
Sales Tax Rate is the percentage set by the taxing authority (e.g., state, local government).

Value-Added Tax (VAT) Calculation:
VAT is a multi-stage tax applied at each step of the production and distribution process on the value added at that stage. The total VAT paid by the consumer is the sum of VAT collected at each stage. Businesses can often claim a credit for VAT paid on their inputs.

\text{VAT at Stage} = (\text{Selling Price} - \text{Cost of Inputs}) \times \text{VAT Rate}

Alternatively, in practice, VAT is often calculated as a percentage of the selling price, and businesses recover VAT paid on their purchases.

\text{VAT Payable by Business} = \text{VAT Collected on Sales} - \text{VAT Paid on Purchases}

where:

Selling Price is the price at which the good or service is sold at a given stage.
Cost of Inputs refers to the expenses incurred for materials or services at an earlier stage.
VAT Rate is the statutory percentage rate.
VAT Collected on Sales is the VAT charged to customers.
VAT Paid on Purchases is the VAT a business paid on goods or services it acquired.

The final consumer pays the full VAT amount embedded in the retail price.

Interpreting the Indirect Tax

Interpreting an indirect tax primarily involves understanding its impact on consumers, businesses, and the overall economy. For consumers, the indirect tax means a higher price for goods and services. For instance, an excise tax on gasoline directly increases the cost at the pump.³¹ Businesses, while acting as the collection agent for the government, must factor these taxes into their pricing strategies and manage compliance with tax regulations.

Economically, the imposition of an indirect tax can lead to changes in consumer behavior, such as reduced demand for taxed goods, especially those with high price elasticity. It also influences supply chain dynamics, as businesses adjust their operations to account for the added cost. The interpretation also extends to its regressive tax nature: because the tax rate is the same for everyone regardless of income, it consumes a larger proportion of income from lower-earning individuals.³⁰ This contrasts with a progressive tax system where higher earners pay a larger percentage of their income in taxes.²⁹

Hypothetical Example

Consider a hypothetical scenario involving an indirect tax in the form of a sales tax. Imagine a state imposes a 6% sales tax on all retail purchases. A consumer buys a new smartphone priced at $800.

Calculate the Sales Tax Amount:
The sales tax amount is calculated as 6% of the purchase price.
$\text{Sales Tax Amount} = \$800 \times 0.06 = \$48$
Determine the Total Cost to the Consumer:
The total cost for the consumer is the smartphone's price plus the sales tax.
$\text{Total Cost} = \$800 + \$48 = \$848$

In this example, the retailer collects the $48 sales tax from the consumer at the point of sale. The consumer pays the total of $848, with the indirect tax embedded in the final price. The retailer then remits the collected sales tax to the state government. This illustrates how the indirect tax is collected by an intermediary (the retailer) and ultimately borne by the consumer, without the consumer directly sending the tax payment to the government. This mechanism is a hallmark of consumption taxes.

Practical Applications

Indirect taxes are widely applied globally and serve various purposes beyond just revenue generation. They are a common feature of tax systems in most countries.

Sales Tax: Many states and local governments in the United States levy a sales tax on most goods and services purchased by consumers.²⁷, ²⁸ This revenue often funds public services such as education and infrastructure.²⁶
Value-Added Tax (VAT): Predominantly used outside the U.S., VAT is a common form of indirect tax in over 170 countries, including all European Union members. It's applied at each stage of production and distribution, with businesses able to reclaim VAT on inputs.
Excise Taxes: These are specific indirect taxes imposed on certain goods, services, or activities, such as fuel, tobacco, alcohol, and airline tickets.²³, ²⁴, ²⁵ Often referred to as "sin taxes," they can be used to discourage consumption of products deemed harmful or to fund specific programs related to the taxed item, like highway improvements from fuel taxes.²¹, ²² The Internal Revenue Service (IRS) provides detailed information and forms for federal excise taxes, such as Form 720 for quarterly reporting.²⁰
Tariffs (Import Duties): These are indirect taxes levied on imported goods and services, increasing their cost and often used to protect domestic industries or generate revenue.¹⁹
Environmental Taxes: Some indirect taxes aim to correct market failures by taxing activities with negative externalities, such as carbon emissions or pollution.¹⁸ This encourages businesses and consumers to adopt more environmentally friendly practices.

These applications demonstrate the versatility of indirect taxes in shaping economic behavior and funding public services, although their regressive nature remains a frequent point of discussion in fiscal policy debates.

Limitations and Criticisms

While indirect taxes are a significant source of government revenue, they face several limitations and criticisms, primarily concerning their impact on equity and economic efficiency.

One of the most prominent criticisms is their regressive nature. Unlike income tax, which can be structured progressively to tax higher earners at a greater percentage, indirect taxes are levied uniformly on goods and services, regardless of the consumer's income level.¹⁷ This means that lower-income households spend a larger proportion of their income on essential goods and services, and thus a greater percentage of their income is consumed by indirect taxes, such as sales tax or VAT.¹⁵, ¹⁶ For example, the excise tax on a gallon of diesel is the same for a low-income farmer as it is for a luxury car owner, making the tax burden disproportionately higher for the farmer relative to their income.¹⁴ This effectively reduces the purchasing power of those with less disposable income more significantly.¹³

Another limitation is their potential to distort economic behavior. By increasing the price of goods and services, indirect taxes can reduce consumer demand, leading to a deadweight loss in the economy. This means that the reduction in consumer and producer surplus exceeds the tax revenue generated, leading to an overall loss of economic welfare.

Furthermore, compliance costs for businesses, especially for multi-stage taxes like VAT, can be considerable due to the extensive record-keeping required for tax credits on purchases.¹² The complexity of certain indirect tax systems, including various exemptions and rates for different goods, can also add administrative burdens for both businesses and tax authorities.

Critics also point to the potential for inflationary effects, as businesses may pass the full cost of indirect taxes on to consumers through higher prices.¹¹ While indirect taxes can be effective in raising revenue and influencing consumption patterns, their impact on income inequality and market distortions are significant concerns in discussions about taxation systems.

Indirect Tax vs. Direct Tax

The fundamental distinction between an indirect tax and a direct tax lies in who is legally responsible for paying the tax to the government and who ultimately bears the economic burden.

Feature	Indirect Tax	Direct Tax
Payer to Government	An intermediary (e.g., manufacturer, retailer) collects the tax and remits it to the government.	The individual or entity on whom the tax is imposed pays it directly to the government.
Economic Burden	The burden is typically shifted to the end consumer through higher prices of goods and services.	The burden generally remains with the individual or entity paying the tax.
Tax Incidence	The legal incidence (who pays the government) and economic incidence (who bears the burden) are different.	The legal and economic incidence usually fall on the same party.
Examples	Sales tax, Value-Added Tax (VAT), excise taxes, customs duties, tariffs.	Income tax (personal and corporate), property tax, capital gains tax, inheritance tax. ⁸, ⁹, ¹⁰
Regressivity	Generally considered regressive, impacting lower-income individuals more disproportionately.	Can be progressive (e.g., income tax), proportional, or regressive, depending on its structure. ⁶, ⁷
Visibility	Often embedded in the price of goods, making them less visible to consumers. ⁵	Typically more visible, as individuals directly pay them (e.g., from paychecks or annual filings).

While both types of taxes contribute to government revenue, their economic and social impacts differ significantly, influencing economic equality and consumer behavior.

FAQs

What are common examples of indirect taxes?

Common examples include sales tax, Value-Added Tax (VAT), excise taxes (on items like tobacco, alcohol, and fuel), and customs duties or tariffs on imported goods.

Why are indirect taxes considered regressive?

Indirect taxes are considered regressive because they are applied uniformly to goods and services, regardless of the buyer's income. As a result, lower-income individuals spend a larger proportion of their income on these taxed goods and services, meaning the tax takes a larger percentage of their overall income compared to higher-income individuals.² This contrasts with a progressive tax system.

Who ultimately pays an indirect tax?

Although an intermediary, such as a retailer or manufacturer, collects the indirect tax and remits it to the government, the ultimate economic burden is typically passed on to the consumer through higher prices for the goods or services. This is known as tax incidence.

How do indirect taxes impact trade?

Indirect taxes, especially tariffs, can influence international trade by making imported goods more expensive, which can reduce their competitiveness against domestic products. VAT systems, however, are often designed to facilitate exports by providing tax refunds on goods shipped out of the country.

Do all countries use indirect taxes?

Yes, most countries utilize some form of indirect taxation to generate government revenue. While the specific types and rates vary, consumption taxes like sales tax or VAT are prevalent globally. The United States, for instance, uses sales taxes at the state and local levels, while many other industrialized nations employ a VAT system.¹