Types of indirect taxes

Indirect taxes are charges imposed by governments on goods and services, collected by sellers and passed on to buyers through higher prices. They differ from direct taxes, which are paid straight from income or profits.

Ad valorem taxes

Ad valorem taxes are calculated as a percentage of the item's selling price. For example, value-added tax (VAT) or goods and services tax (GST) might add 12% to the cost of a product, so the amount of tax rises with the price.

Specific taxes

Specific taxes involve a fixed amount per unit or quantity, regardless of price. For instance, a tax of £0.60 per litre on fuel means the charge stays the same for each unit bought.

Purposes of indirect taxes

Governments use indirect taxes to influence economic behaviour and generate revenue without directly targeting individuals' earnings.

Reasons for introducing indirect taxes:

• Discouraging harmful consumption - They target demerit goods, like cigarettes or sugary drinks, by raising prices to reduce demand and limit negative effects on health or society.
• Shifting costs to consumers - Although levied on producers or sellers, these taxes are often added to the final price, meaning buyers ultimately pay more.

Effects of imposing indirect taxes

Introducing an indirect tax alters market dynamics, affecting both supply and demand.

Changes caused by a specific indirect tax:

• Shift in the supply curve - The supply curve moves leftward by the tax amount, as sellers face higher costs per unit.
• Rise in market price - The new equilibrium price increases from the original level, making goods more expensive for buyers.
• Fall in quantity traded - Fewer units are bought and sold at the higher price, reducing overall market activity.

Incidence of indirect taxes and factors affecting it

Tax incidence refers to how the burden of a tax is shared between producers and consumers.

How tax burden is shared

Both producers and consumers are affected when an indirect tax is imposed. Producers receive less revenue per unit after tax, while consumers pay more. The split varies; if the consumer's share (area A on a diagram) is smaller than the producer's (area B), sellers bear more of the cost. Overall, both parties lose out, with higher prices for buyers and lower net income for sellers.

Factors influencing tax incidence

Price elasticity of demand measures how sensitive buyers are to price changes, and this significantly affects how the tax burden is shared.

Impact of price elasticity:

• Inelastic demand - If demand is price inelastic (e.g., for essentials like petrol), sellers can pass most of the tax to consumers via higher prices without losing many sales.
• Elastic demand - If demand is price elastic (e.g., for luxury items), buyers reduce purchases significantly when prices rise, forcing producers to absorb more of the tax to avoid losing revenue.

Governments often tax inelastic goods heavily, as consumers continue buying, ensuring steady tax income.

Tax collection challenges and structures in different economies

Collecting taxes efficiently varies by economic development, with indirect taxes often preferred in certain contexts due to ease of administration.

Difficulties in developing economies

Challenges in tax collection:

• Low compliance rates - In many low- and middle-income countries, few people file tax returns; for example, in some large nations, under 2% of workers submit them.
• Reliance on cash - Cash transactions dominate, making it hard to track and tax income or sales accurately.
• Policy responses - Some governments withdraw high-value notes (demonetisation) to push for digital payments and improve tracking.
• Preference for indirect taxes - Emerging economies favour these over direct taxes, as they are simpler to collect through sellers.

Comparison of tax structures

Tax systems differ between emerging and developed economies, balancing direct and indirect methods to fund public services. Direct taxes focus on income and profits, while indirect ones apply to transactions, with rates adjusted to suit economic needs.