An indirect tax is a tax that is paid through another party and then by the taxpayer. Taxes are always paid to some government entity, usually the IRS for federal taxes or the state where the transaction takes place. But in many cases, the consumer isn't aware that the tax is being paid, which is why they are sometimes called hidden taxes. It's easier to explain indirect taxes by comparing them to direct taxes and giving you some examples.
Indirect taxes are placed on goods and services which raise the price so that the consumer pays more for the item. You might want to think of indirect taxes as hidden taxes. Here's a simple example of an indirect tax: the gasoline tax. The gasoline tax rate is set by states. If you buy gasoline in Texas, the gasoline tax there is 20 cents per gallon. The tax is added to the price of gas. The producer pays the tax to the state, and it's built into the price you pay for gas.
How Direct Taxes Differ From Indirect Taxes
The best example of a direct tax is income taxes, both personal income taxes and business income taxes The tax is paid directly on the income of the person or business to the IRS and to the state (if it has income taxes).
Other direct taxes are:
The estate tax or wealth tax, which is paid based on the value of everything owned by the deceased at the time of death.
Capital gains taxes are directly imposed on investors when they sell an investment for a gain.
Sales taxes are also considered direct taxes because they are imposed on individual customers at the time of purchase.
5 Examples of Indirect Taxes
Import Duties or Tariffs: Import duties are a type of indirect tax because they are imposed on goods when they come into the country. The customer ultimately pays this tax as an increased price for the goods. Tariffs are imposed by countries on each others' goods, and they are usually managed and greed on through free trade agreements.
Excise Tax: Excise taxes are use taxes; you pay a tax for using or buying a product. But you don't see the tax because it is paid by the producer or manufacturer and included in the price of the product. Excise taxes are sometimes called sin taxes because they are on products considered unnecessary or "sinful," like tobacco, alcohol, or gambling. As mentioned above, gasoline taxes are excise taxes.
Businesses also pay excise taxes on their use of specific products. For example, fuel taxes are excise taxes, as are taxes on environmental products, such as domestic petroleum oil spills and ozone-depleting chemicals. Transportation companies pay excise taxes in the form of airport fees and ship passenger taxes; car manufacturers pay an excise fee (especially for cars with lower fuel efficiency). Hotel fees might be considered excise taxes, but these are usually directly passed on to customers in their bills.
VAT Tax: VAT taxes are common in Europe and other countries but aren't used in the U.S. A VAT tax or value-added tax is a series of taxes imposed on the production of products all through the process, with the customer paying the final tax. A VAT is different from sales tax because the only one paying sales tax is the consumer.
By the way, when you shop at a "duty-free" store at an airport, it's the VAT tax you are avoiding. That doesn't mean you get a bargain, because the price may be higher.
Communications Service Tax: Service taxes are determined by each state and they include taxes on cable and satellite TV services, phone services, and mobile communications. In some states, the charges are passed on to the customers.
Stamp Tax: Stamp taxes are imposed by states on documents (the stamp in these cases is like a notary stamp, not a postage stamp). For example, stamp taxes are often required on public documents for the transfer of property, like a mortgage. The stamp tax may be included in the cost of the document, so it would be an indirect tax.
Are Indirect Taxes Regressive Taxation?
Regressive taxes are those taxes which impose greater taxes on lower-income individuals than higher income individuals. For example, lower income taxpayers can pay a greater percentage of their income for items they need or choose to buy. Tariffs can be regressive because they raise the price of food and other items. Sales tax is also a regressive tax because it hits lower-income people more for things like clothing and household goods.
The combination of tariffs (an indirect tax) and sales tax (a direct tax) hits the poor with a double tax hit, raising the prices of goods they need to buy and increasing the sales tax they must pay.