What is Indirect Tax and Why is It Imposed?

Jaya Sharma
Senio r Executive Co ntent

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.

T able of Contents

What is Indirect T ax?

Why Indirect T ax is Regressive in Nature?

Does Indirect T ax Af f ect Supply or Demand?

What are the T wo T ypes of Indirect T ax?

Why are Indirect T axes Imposed?

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o n 16 -Jan-20 24.
What is Indirect Tax?

Indirect tax is levied on the production, sales and consumption of goods and services. T his
tax is collected at dif f erent 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. T he seller then
remits this tax to the government. Indirect tax shif ts the tax burden f rom 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 f rom lower-income

individuals. Other than that, several f actors make this type of tax regressive in nature:

Flat Rate on Goods and Services: Indirect taxes are typically levied as a f lat rate on
goods and services. T his means that everyone pays the same amount of tax f or a
specif ic 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 f lexibility to change their
consumption patterns in response to taxes. For example, if a necessary item like f uel or
f ood is taxed, they cannot easily avoid these taxes by not consuming these items, as
these are essential f or 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. T his unif ormity
means that the tax does not consider the individual's ability to pay, unlike direct taxes like
income tax, which are of ten 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. T his
disproportionately af f ects lower-income individuals, as they cannot reduce their
consumption of these essentials even when prices rise.

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o n 16 -Jan-20 24.
 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 Af f ect 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 af f ect 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 manuf acturers 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. T his leads to a decrease in the
demand f or 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 T ax: T his type of tax is levied as a percentage of the value of the good or
service. T he tax amount varies depending on the price of the product. Common examples
include:

Value-Added T ax (VAT ): Imposed on the value added at each stage of production and
distribution of goods and services. VAT is a common f orm of indirect tax used in many
countries.

Goods and Services T ax (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 of ten
implemented as a replacement f or various other indirect taxes.

Sales T ax: 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.

Explore GST courses

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2. Specific T ax: T his type of tax is levied as a specif ic amount per unit of a good or service,
regardless of its price. T he tax amount is f ixed and does not change with the value of the
product. Examples include:

Excise Duty: Imposed on specif ic goods, such as tobacco, alcohol, and f uel. Excise
duties are of ten levied to discourage the consumption of these goods f or health or
environmental reasons.

Customs Duty: Charged on items imported into a country. T he 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 f or several reasons, serving both f iscal and non-f iscal objectives:

1. Fiscal Reasons

Revenue Generation: One of the primary reasons f or imposing indirect taxes is to

generate revenue f or the government. T hese taxes are a signif icant source of income f or
many governments and help f und public services and inf rastructure.

Ease of Collection: Indirect taxes are of ten easier to administer and collect compared to
direct taxes. T hey 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. T his allows f or the collection of substantial revenue even at
relatively low rates.

Reduced Evasion: T he 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 harmf ul 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 f rom f oreign competition, while lower

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 taxes on certain goods can stimulate demand f or them.

Inflation Control: In some cases, indirect taxes can be adjusted to help control inf lation.
For example, reducing indirect taxes on essential goods can help lower their prices,
thereby reducing inf lationary 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.

T rade Policy: Customs duties, a f orm 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 f or policy goals?

What is Value Added T ax (VAT )?

Can indirect taxes inf luence consumer behavior?

What is the purpose of indirect taxes?

How do indirect taxes dif f er f rom direct taxes?

Disclaim e r: This PDF is auto -generated based o n the info rmatio n available o n Shiksha as
o n 16 -Jan-20 24.