What is indirect tax, and how does it work?

1 min read by Rachel Carey Last updated June 25, 2024

Learn about indirect taxes in the US, compare them to direct taxes and VAT used in other countries, and discover the impact on consumer prices and government revenue.

Summary

  • Sales tax rates varied widely across US states, ranging from 0% to over 7%.

  • Excise taxes impact the cost of goods like gasoline, alcohol, and tobacco.

  • The US sales tax system differed significantly from the value-added tax (VAT) system used in many other countries.

  • Unbiased can match you with a financial advisor who can help you develop a comprehensive tax strategy that can save you money. 

What is indirect tax?

An indirect tax is a tax levied on goods and services rather than on income or profits. 

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The tax is collected by an entity such as a retailer but is ultimately passed on to the consumer, who carries the cost of the tax by paying the price of the product or service.

What are indirect taxes in simple terms?

When you buy a product or service, the price you pay includes the cost of producing it, the seller's profit margin, and the indirect tax. 

The seller collects this tax from you and then pays it to the government.

Legally, the business or retailer is responsible for collecting and remitting the indirect tax to the government. Economically, the consumer bears the economic burden of the tax, as it is included in the price of the goods and services they purchase.

How does indirect tax work?

Indirect taxes are levied on goods and services, not directly on income

The seller collects the tax from the consumer and passes it to the government. 

This makes goods and services more expensive for consumers, who ultimately bear the tax burden.

How does indirect tax work in terms of governmental usage?

Governments use indirect taxes for several reasons:

  • Revenue generation: They are a major income source.

  • Ease of collection: Collected at the point of sale.

  • Economic regulation: Can discourage consumption of certain goods or promote industries.

  • Broader tax base: Applies to a wider range than income-based taxes.

What is the difference between direct and indirect tax?

Direct taxes are imposed on income, wealth, or profits and are paid directly to the government by individuals or businesses. Examples include income tax, property tax, and corporate tax. These taxes are often progressive, meaning higher earners pay a larger percentage of their income.

Indirect taxes, on the other hand, are levied on goods and services and are indirectly paid by consumers through increased prices. Examples include sales tax, excise tax, and value-added tax (VAT). These taxes are often regressive, meaning they affect lower-income earners more disproportionately because everyone pays the same rate regardless of income level.

The key difference is that direct taxes cannot be shifted onto others, while the burden of indirect taxes can be passed on to consumers. 

What are examples of indirect tax?

Indirect taxes come in various forms, impacting a wide range of goods and services. Here are some common indirect tax examples:

  • Sales tax: This is the most prevalent indirect tax in the United States. It's added to the purchase price of most goods and services at the point of sale. Rates vary by state and even locality.

  • Excise tax: This tax is levied on specific goods like gasoline, alcohol, tobacco, and airline tickets. It's often included in the price of the product and can vary significantly depending on the item and location.

  • Value-added tax (VAT): While not implemented in the US, VAT is a common indirect tax in many countries. It's a consumption tax that's added at each stage of production, with the consumer ultimately bearing the final cost.

  • Customs duties (tariffs): These are taxes imposed on goods imported from other countries. They can be a percentage of the value of the goods or a fixed amount per unit.

  • Other indirect taxes: Some less common examples include occupancy taxes on hotel rooms, amusement taxes on entertainment events, and fuel taxes.

What is value-added tax?

Value-Added Tax (VAT) is a consumption tax added at each production stage. 

Unlike sales tax, which is applied once at the final sale, VAT is collected incrementally. 

Businesses can deduct the VAT they've paid on inputs, and the consumer ultimately pays the total VAT.

Key differences from other indirect taxes:

  • Multi-stage: Applied throughout the supply chain.

  • Credit mechanism: Businesses can deduct VAT paid on inputs.

  • Transparent: Visible at each stage.

  • Common worldwide: Used in many countries, unlike the US, which primarily uses sales tax.

Get expert financial advice

Indirect taxes, such as sales, excise, and value-added taxes (VAT), are levied on goods and services, impacting consumer prices. Unlike direct taxes on income, these are often hidden within the final price you pay. 

While the US primarily relies on sales tax, other countries commonly use VAT, a multi-stage tax applied throughout production. Understanding these taxes is crucial for making informed financial decisions.

Let Unbiased connect you with an SEC-regulated financial advisor for personalized guidance on tax planning and financial strategies tailored to your unique circumstances.

Senior Content Writer

Rachel Carey

Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.

Get help with your taxes

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