Direct versus Indirect Taxation

In the last twenty years there has been a shift towards indirect taxation – economists differ in their views about what is the optimum Direct versus Indirect Taxation mix of taxation between indirect and direct taxes

Arguments For Using Indirect Taxation Arguments Against Using Indirect Taxation
  • Changes in indirect taxes are more effective in changing the overall pattern of demand for particular goods and services i.e. in changing relative prices and thereby affecting consumer demand (e.g. an increase in the real duty on petrol)
  • Many indirect taxes make the distribution of income more unequal (less equitable) because indirect taxes are more regressive than direct taxes
  • They are a useful instrument in controlling and correcting for externalities – all governments have moved towards a more frequent use of indirect taxes as a Direct versus Indirect Taxation means of making the polluter pay and “internalizing the external costs” of production and consumption
  • Higher indirect taxes can cause cost-push inflation which can lead to a rise in inflation expectations
  • Indirect taxes are less likely to distort the choices that people have to between work and leisure and therefore have less of a negative effect on work incentives. Higher indirect taxes allow a reduction in direct tax rates (e.g. lower starting rates of income tax)
  • There is no hard evidence that cutting direct tax rates has much of an incentive effect on people’s decisions Direct versus Indirect Taxation about whether or not to work. If indirect taxes are too high – this creates an incentive to avoid taxes through“boot-legging” – a good example of this would be attempts to evade the high levels of duty on cigarettes
  • Indirect taxes can be changed more easily than direct taxes – this gives economic policy-makers more flexibility when setting fiscal policy. Direct taxes can only be changed once a year at Budget time
  • Revenue from indirect taxes can be uncertain particularly when inflation is low or there is a recession causing a fall in consume spending
  • Indirect taxes are less easy to avoid by the Direct versus Indirect Taxation final tax-payer who might be unaware of how much indirect tax they are paying
  • There is a potential loss of economic welfare (taxes can create a deadweight loss of consumer and producers surplus)
  • Indirect taxes provide an incentive to save (and thereby avoid the tax)- a higher level of savings might be used by the economy to finance a higher level of capital investment
  • Higher indirect taxes affect households on lower incomes who are least able to save in the first place
  • Indirect taxes leave people free to make a choice whereas direct taxes leave people with less of their Direct versus Indirect Taxation gross income in their pockets
  • Many people are unaware of how much they are paying in indirect taxes – this goes against one of the basic principles of a good tax system – namely that taxes should be transparent

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