What Are Indirect Taxes and How Do They Work?

An indirect tax is a levy on goods and services collected by an intermediary, such as a retailer, rather than directly by the government. While the business remits the tax payment, the financial burden is passed on to the consumer as part of the total purchase price. The final cost of a product or service includes a tax amount that the customer pays, even if it is not itemized separately.

The Fundamental Distinction from Direct Taxes

Taxes can be separated into two categories based on who bears the financial burden. A direct tax is levied on the income or profit of an individual or organization, such as personal income tax. The person or entity earning the funds pays the government directly, with no intermediary involved.

An indirect tax functions differently because the entity responsible for sending the tax payment to the government is not the one that ultimately bears the cost. The business that collects the tax from a customer experiences the impact of collection, but the final economic burden falls on the consumer who pays a higher price.

This transfer of the tax burden from the business to the end consumer is the defining feature of indirect taxation. The more a person consumes, the more indirect tax they pay, which contrasts with direct taxes that are calculated based on earnings or profits, not consumption.

Key Categories of Indirect Taxes

Sales Tax

Sales tax is a consumption tax on goods and services collected by the seller at the final point of sale. As a single-stage tax, it is applied only once at the retail level. The tax is calculated as a percentage of the product’s price and added to the customer’s bill, and businesses are responsible for remitting these collected funds to the relevant state or local tax department.

Value-Added Tax (VAT)

While common in many countries, the United States does not have a national Value-Added Tax (VAT). A VAT is a consumption tax levied at each stage of the supply chain where value is added to a product. For instance, a manufacturer pays VAT on raw materials and a wholesaler pays VAT on the finished goods. To prevent double taxation, businesses can receive a credit for the VAT they paid on their own purchases, ensuring the final consumer bears the tax burden.

Excise Taxes

Federal excise taxes are applied to a specific list of goods and services, often to generate revenue, discourage consumption, or fund related government initiatives. These taxes are levied on producers or wholesalers and are included in the final price paid by consumers. Common examples include:

• Tobacco
• Alcohol
• Fuel
• Airline tickets
• Heavy trucks and tractors

Customs Duties and Tariffs

Customs duties and tariffs are taxes imposed on goods imported from other countries. These fees are collected by customs authorities to generate revenue for the government and to protect domestic industries from foreign competition by making imported goods more expensive. The amount of the duty can vary based on the type of good, its value, and its country of origin.

The Collection and Remittance Process

For businesses, handling indirect taxes involves a structured process of calculation, collection, and remittance. The first step is to correctly calculate the applicable tax on a customer’s purchase. This can be particularly complex in the United States as sales tax rates vary significantly between jurisdictions.

Once the tax is calculated and added to the sale, the business collects the total amount from the customer. The tax amounts collected are not revenue for the business; they are held in trust for the government. Businesses must segregate these tax collections from their own revenue to ensure they are available for remittance.

The final step is filing the necessary tax forms and remitting the collected funds to the appropriate government agency. This is done on a periodic basis, which can be monthly, quarterly, or annually, depending on the jurisdiction and the amount of tax collected.