INDIRECT TAXES

Government has to perform many functions in the discharge of

its duties like infrastructure development, health, education,
defence of the country, removal of poverty, maintenance of law
and order, etc. To meet these requirements huge amount of
capital is required. The question arises, from where does
government get money for fulfilling all these activities and for
the development of the nation? The government collects money
from public through a wide variety of sources i.e. fees, fines,
surcharges and taxes which are defined later in this lesson. The
most important of these is taxation. In this lesson we will discuss
various types of indirect taxes in details.

Taxation—the raising of revenue —is about power, a subject

that has excited much controversy throughout history. The
Magna Carta of 1215, considered a watershed in the evolution of
representative government, came about because of an English
king's arbitrary imposition of taxes, without the consent of those
being taxed. The issue was not about taxes themselves, but how
1
they were being imposed. From then on, English rulers were
deprived of the "power of the purse," which, for the most part,
shifted to the taxpayers as represented by Parliament.

The concept of consent endured, elevated by English

philosopher John Locke (1632-1704) into a constitutional
principle. Locke maintained that government existed in order to
protect liberty and the right of property; even so, it had no
inherent right to tax without consent. Hence, since the Magna
Carta the matter of taxation—the power to raise revenue—
continued to buttress representative government. In 1689 the
English "Bill of Rights" explicitly guaranteed the right of
taxation only to parliament. This was a dramatic departure in the
5,000-year history of taxation.

Another significant change has been the shared responsibility of

all segments of society in the payment of taxes. In the United
States, everybody from George Washington to the humble
distiller of whiskey paid taxes. In medieval Europe and Russia,
those least able to pay—the oppressed peasantry—carried most
or the entire tax burden. Taxes were a social stigma. This

2
changed with the evolution of the concept of taxation with
representation, and its corollary: the responsibility of all to pay.
In the early years of the American republic, so firmly entrenched
was the idea that those who paid were those who ruled that the
payment of property taxes (the only form of personal, individual
tax in those days) became a more important voting criterion than
mere citizenship.

Finally, the concept that those who are most able to afford to
pay tax should pay the most—the "progressive" concept of
taxation—is perhaps the most recent evolution in the history of
taxation. It is nevertheless limited to the income tax, which in
itself is the embodiment of the concept of everyone's
responsibility to shoulder the tax burden.

Despite these changes over time, taxation is as old as recorded

history. Today as in ancient times, all taxes fall into broad
categories: direct and indirect. A direct tax is one that a person
pays directly, as with income tax. An indirect tax is one that is
usually figured into the price of a product, with the purchaser
often unaware of its existence.

3
This is a tax that is levied indirectly, as one levied on
commodities before they reach the consumer but ultimately paid
by the consumer as part of the market price.

The term indirect tax has more than one meaning. In the
colloquial sense, an indirect tax (such as sales tax, a specific tax,
value added tax (VAT), or goods and services tax (GST)) is
a tax collected by an intermediary (such as a retail store) from
the person who bears the ultimate economic burden of the tax
(such as the consumer). The intermediary later files a tax return
and forwards the tax proceeds to government with the return. In
this sense, the term indirect tax is contrasted with a direct tax
which is collected directly by government from the persons
(legal or natural) on which it is imposed. Some commentators
have argued that "a direct tax is one that cannot be shifted by the
taxpayer to someone else, whereas an indirect tax can be."

It is imposed on expenditure. In simple terms, it is a tax which is

imposed on goods and services sold. It is usually added to the
cost of the good or service and charged from the ultimate
consumer. The seller will then file a return to the government on
all the taxes he has collected from the consumer.
4
Indirect taxes are flat taxes: Everyone who buys or uses the
goods or services is taxed at the same rate.

Examples are sales tax and excise duty.

Consequences of imposing indirect tax
Imposition of tax results in three economic observations.
1. Incidence: Incidence of tax means the party who actually
pays the tax.
2. Government revenue: the amount of tax government will
receive as revenue
3. Resource allocation: the amount of fall in quantity
demanded and produced created by the tax.
Incidence or tax burden
When a tax imposed on a good or service increases the price by
the amount of the tax, the burden of the tax falls on consumers.
If instead it lowers wages or lowers prices for some of the other
factors of production used in the production of the good or
service taxed, the burden of the tax falls on owners of these
factors.

5
Government revenue
Putting taxes on goods and services generates revenue for the
government.

The modern practice of implementing indirect taxes was initially

adopted by the French government in 1954 as a way to collect
taxes on smuggled goods (goods that had not had tariffs
collected). Since that time, indirect taxes have become a major
source of income for the French government.

An indirect tax is one which the burden can be shifted to others.

The taxpayer is not the tax bearer. The impact and incidence of
indirect taxes are on different person. An indirect tax is levied
on and collected from a person who manages to pass it on to
some other person or person on whom the real burden of tax
falls.

It is imposed on expenditure. In simple terms, it is a tax which is

imposed on goods and services sold. It is usually added to the
cost of the good or service and charged from the ultimate
consumer. The seller will then file a return to the government on
all the taxes he has collected from the consumer.
6
Examples are sales tax and excise duty
The taxes levied on the basis of incidence and impact is called
direct or indirect taxes. The tax which cannot be shifted to other
is called direct tax and the tax which can be shifted to other is
called indirect tax. If the tax is paid by the same person on
whom it is levied, it-is called a direct tax. The incidence and
impact of this tax fall on the same person. For example, income
and property taxes are the direct taxes which should be paid by
the person on whom it is imposed. They cannot be shifted to
others. These taxes are also known as personal tax.

If a tax is levied on one person but is paid by other person either

partially or fully, it is called indirect tax. The incidence and
impact of tax fall on different persons. The sales tax, excise
duty, exports and import taxes are the example of indirect tax.
These taxes are shifted to the consumers by adding in the price
of goods and services. The consumers are the ultimate payers of
the tax though it is imposed on producers and sellers. These
taxes are also known as impersonal taxes.

7
According to Dalton direct tax is really paid by the person on
whom it is legally imposed. The indirect tax is “imposed upon
one person but paid partly or wholly by another”.

Some people classify direct and indirect taxes on the basis of

administrative arrangements. In case of direct tax there is direct
relationship between the taxpayer and the revenue authorities. A
tax collecting agency directly collects the tax from the taxpayer,
where as in case of indirect taxes there is no direct relationship
between the taxpayers and the revenue authorities. They are
collected through traders and manufacturers.

Salient Features of Indirect Taxes

1. Shifting of tax burden

2. Commodity tax

3. Ability of taxpayer is indirectly determined

4. Taxpayer does not perceive a direct pinch while paying

indirect tax

5. Easier to collect
8
 6. Evasion is comparatively less

7. Indirect taxes affect the price of goods.

Advantages/Merits of Indirect Taxes

1. Convenient

Indirect taxes are imposed on production, sale and movement of

goods and services. These are imposed on manufacturers, sellers
and traders but their burden may be shifted o consumers of
goods and services who are the final taxpayers. Such taxes in the
form of higher prices are paid only on purchase of a commodity
or the enjoyment of service. So taxpayers do not feel the burden
of these taxes. Besides, money burden of indirect taxes is not
completely felt since the tax amount is actually hidden in the
price of the commodity bought. They are also convenient
because generally they are paid in small amounts and at intervals
and are not in lump sum. They are convenient on the part of the
government also, since the tax amount is collected generally as a
lump sum from the manufacturers or traders.

9
 2. Difficult to evade

Indirect taxes have in-built safeguards tax evasion. Indirect taxes

are paid by customers and the sellers have to collect them and
remit the same to the government. In the case of many products,
the selling price is inclusive of indirect taxes. Therefore, the
customer has no option to evade the indirect tax.

3. Elastic

Some of the indirect taxes are elastic in nature. When the

government feels it necessary to increase revenues, it increases
these taxes. In times of prosperity indirect taxes produce huge
revenues to the government.

4. Wide coverage

Unlike direct taxes, indirect taxes have very wide coverage.

Majority of goods or services are subject to indirect taxes. The
consumers and users of such goods and services have to pay
them.

10
 5. Universality

Indirect taxes are paid by all classes of people and so they are
broad based. Poor people may be out of the net of income tax,
but they pay indirect taxes when they buy goods.

6. Influence on Pattern of Production

By imposing taxes on certain commodities or sectors, the

government can achieve better allocation of resources. For
example by imposing taxes on luxurious goods and making
them more expensive, government can divert resources from
these sectors to sector producing necessary goods.

7. May not affect motivation to work and save

Indirect taxes may not affect motivation to work and save since
they are not progressive in nature. Individuals may not mind to
pay them. In other words, indirect taxes are regressive in nature.
Therefore individuals may not be demotivated to work and save,
which may increase investment.

11
 8. Social Welfare

Indirect taxes promote social welfare. The amount collected by

way of indirect taxes is utilized by government for social
welfare activities including education, health, etc. secondly, very
high taxes are imposed on the consumption of harmful products
such as alcoholic products, tobacco products and such other
products. So it is not only to check their consumption but also
enables the state to collect substantial revenue in this manner.

9. Flexibility and Buoyancy

Indirect taxes are more flexible and buoyant. Flexibility is the

ability of the tax system to generate proportionately higher tax
revenue with a change in tax base, and buoyancy is a wider
concept, as it involves the ability of the tax system to generate
proportionately higher tax revenue with a change in tax base, as
well as tax rates.

12
 10. Mass Participation

There is mass participation. Each and every person getting

goods or services has to pay indirect tax.

Disadvantages/Demerits of Indirect Taxes

1. Increase Income Inequalities

Generally, indirect taxes are regressive in nature. The rich and

the poor have to pay the same rate of indirect taxes on certain
commodities of mass consumption. This may further increase
income disparities among the rich and the poor.

2. Affect Consumption

Indirect taxes affect consumption of certain commodities. For

example, a very high rate of duty on certain goods such as
consumer durables may restrict the use of such products.
Consumers belonging to the middle class group may delay their
purchases, or they may not buy at all. The reduction in
consumption affects the investment and production activities,
which in turn hampers economic growth.

13
 3. Lack of Social Consciousness

Indirect taxes do not create any social consciousness as the

taxpayers do not feel the burden of the taxes they pay.

4. Uncertainty

Indirect taxes are often rather uncertain. Taxes on commodities

with elastic demand are particularly uncertain, since quantity
demanded will greatly affect as prices go up due to the
imposition of tax. In fact a very high rate of tax on a particular
commodity may not bring in more revenue.

5. Inflationary

Indirect taxes are inflationary in nature. The taxes charged in

goods and services increase their prices. Therefore, to reduce
inflationary pressure, the government may reduce the tax rates
especially, on essential commodities.

14
 6. Possibility of Tax Evasion

There is possibility of tax evasion as some customers may not

pay indirect with the support of sellers. For instance, individuals
may purchase commodities without a receipt, therefore not pat
VAT.

7. High Cost of Collection

Indirect tax fails to satisfy the principle of economy. The

government has to set up elaborate machinery to administer
indirect taxes. Therefore, cost of tax collection per unit of
revenue raised is generally higher in the case of most of the
indirect taxes.

8. Regressive

Indirect taxes are regressive. Every consumer of a taxed

commodity, rich or poor pays the fax at the same rate. The real
burden of the tax on the poor is greater than on the rich.

15