What is Indirect Tax and Why is It Imposed?

What is Indirect Tax and Why is It Imposed?

6 mins readComment
Jaya
Jaya Sharma
Assistant Manager - Content
Updated on Jan 15, 2024 16:17 IST

Indirect tax is a type of tax collected by an intermediary from the taxpayer. This type of tax is levied on goods and services. Indirect tax is a flat rate on goods and services irrespective of the purchaser's income. 

What is Indirect Tax?

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What is Indirect Tax?

Indirect tax is levied on the production, sales and consumption of goods and services. This tax is collected at different stages of the production and distribution process. Whenever a consumer buys a product, he or she has to pay the price inclusive of the tax. The seller then remits this tax to the government. Indirect tax shifts the tax burden from the seller to the consumer of the good or service.

Why Indirect Tax is Regressive in Nature?

Indirect tax is regressive as it takes a larger percentage of income from lower-income individuals. Other than that, several factors make this type of tax regressive in nature:

  • Flat Rate on Goods and Services: Indirect taxes are typically levied as a flat rate on goods and services. This means that everyone pays the same amount of tax for a specific good or service, regardless of their income level.
  • Higher Proportion of Income for Low Earners: Lower-income individuals spend a larger proportion of their income on consumption than higher-income individuals. Since indirect taxes are charged on goods and services, a greater portion of the income of low earners goes towards paying these taxes. For example, if a rich person and a poor person buy the same taxed item, the tax represents a smaller percentage of the rich person's income than the poor person's income.
  • Limited Substitution Options: Lower-income groups have less flexibility to change their consumption patterns in response to taxes. For example, if a necessary item like fuel or food is taxed, they cannot easily avoid these taxes by not consuming these items, as these are essential for daily living.
  • Non-Discrimination of Consumption: Indirect taxes are imposed on the consumption of goods and services without discrimination between the rich and the poor. This uniformity means that the tax does not consider the individual's ability to pay, unlike direct taxes like income tax, which are often progressive and based on the taxpayer's ability to pay.
  • Inelastic Demand for Essentials: For many goods, especially essentials, demand is inelastic – people need to buy them regardless of price increases due to tax. This disproportionately affects lower-income individuals, as they cannot reduce their consumption of these essentials even when prices rise.
  • Limited Savings Impact: Higher-income individuals can save and invest a larger proportion of their income, which is not subject to indirect taxes. In contrast, lower-income individuals spend a larger share of their income on consumption, subject to these taxes.

Does Indirect Tax Affect Supply or Demand?

Yes, in general, indirect tax reduces supply and demand because of production costs and reduced purchasing power. Since indirect taxes are levied on consumers, such taxes disproportional affect low-income households that spend a large portion of income on basic necessities. 

  • Impact on Supply: When indirect tax is imposed on producers, it increases the production cost which leads to a decrease in supply since manufacturers increase the price of the good or service. 
  • Impact on Demand: By paying indirect taxes, consumers have less disposable income which ultimately decreases their purchasing power. This leads to a decrease in the demand for goods and services since consumers have less money to spend.

What are the Two Types of Indirect Tax?

Indirect taxes can be broadly categorized into two main types:

1. Ad Valorem Tax: This type of tax is levied as a percentage of the value of the good or service. The tax amount varies depending on the price of the product. Common examples include:

  • Value-Added Tax (VAT): Imposed on the value added at each stage of production and distribution of goods and services. VAT is a common form of indirect tax used in many countries.
  • Goods and Services Tax (GST): Similar to VAT, GST is a multi-stage tax levied on the supply of goods and services. It is designed to be comprehensive and is often implemented as a replacement for various other indirect taxes.
  • Sales Tax: Applied to the sale of certain goods and services at a single point of sale. It is a percentage of the retail price and is visible to the consumer at the point of purchase.

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2. Specific Tax: This type of tax is levied as a specific amount per unit of a good or service, regardless of its price. The tax amount is fixed and does not change with the value of the product. Examples include:

    • Excise Duty: Imposed on specific goods, such as tobacco, alcohol, and fuel. Excise duties are often levied to discourage the consumption of these goods for health or environmental reasons.
    • Customs Duty: Charged on items imported into a country. The tax is typically based on the quantity or volume of the imported goods, not their value.

Why are Indirect Taxes Imposed?

Indirect taxes are imposed for several reasons, serving both fiscal and non-fiscal objectives:

1. Fiscal Reasons

  • Revenue Generation: One of the primary reasons for imposing indirect taxes is to generate revenue for the government. These taxes are a significant source of income for many governments and help fund public services and infrastructure.
  • Ease of Collection: Indirect taxes are often easier to administer and collect compared to direct taxes. They are collected by intermediaries (like businesses) at the point of sale or production, reducing the administrative burden on the government.
  • Broad Base: Since indirect taxes are levied on a wide range of goods and services, they have a broad tax base. This allows for the collection of substantial revenue even at relatively low rates.
  • Reduced Evasion: The chance of tax evasion is lower with indirect taxes as they are collected at the point of transaction and embedded in the price of goods and services.

2. Non-Fiscal Reasons

  • Regulating Consumption: Governments use indirect taxes to discourage the consumption of harmful products like tobacco, alcohol, and environmentally damaging goods. By increasing the cost of these products, consumption can be reduced, which aligns with public health and environmental goals.
  • Economic Policy: Indirect taxes can be used to regulate economic activities. For example, high import duties can protect domestic industries from foreign competition, while lower taxes on certain goods can stimulate demand for them.
  • Inflation Control: In some cases, indirect taxes can be adjusted to help control inflation. For example, reducing indirect taxes on essential goods can help lower their prices, thereby reducing inflationary pressures.
  • Social Objectives: Indirect taxes can also be used to achieve social objectives. For instance, taxes on luxury goods can be used to promote a more equitable distribution of resources.
  • Trade Policy: Customs duties, a form of indirect tax, are used in international trade to regulate imports and exports, protect domestic industries, and generate revenue.

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FAQs

How do governments use indirect taxes for policy goals?

Governments use indirect taxes to achieve various policy goals, including environmental protection (e.g., taxes on polluting goods), public health (e.g., taxes on alcohol and tobacco), and economic strategies.

What is Value Added Tax (VAT)?

VAT is a type of indirect tax imposed on the value added to goods and services at each stage of production or distribution.

Can indirect taxes influence consumer behavior?

Yes, by making certain goods more expensive, indirect taxes can discourage their consumption. For example, high taxes on tobacco are intended to reduce smoking rates.

What is the purpose of indirect taxes?

Indirect taxes serve to generate revenue for the government, regulate consumption patterns (especially of harmful goods), and sometimes protect domestic industries through tariffs on imports.

How do indirect taxes differ from direct taxes?

Indirect tax is levied on consumption of goods and services and are paid by the end consumer. In contrast, direct taxes are levied on the income or wealth of individuals or organizations.

About the Author
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Jaya Sharma
Assistant Manager - Content

Jaya is a writer with an experience of over 5 years in content creation and marketing. Her writing style is versatile since she likes to write as per the requirement of the domain. She has worked on Technology, Fina... Read Full Bio