Direct and indirect taxation

Overview

Direct tax.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is a direct tax?

   Model answer

   A direct tax is levied on the income, wealth or profit of a person or organisation and is paid straight to the tax authority by the individual or firm on whom it is imposed. Income tax, national insurance contributions, corporation tax, capital gains tax and inheritance tax are examples. The defining feature is that the person legally liable is also the person who bears the burden.

2. 2

   What is an indirect tax?

   Model answer

   An indirect tax is levied on spending rather than on income or wealth, and it is collected by the seller and handed over to the tax authority rather than paid directly by the consumer. Value added tax, excise duties on fuel, alcohol and tobacco, and air passenger duty are examples. Its defining feature is that the burden can be shifted, wholly or partly, from the firm that pays it to the customer who buys the good.

3. 3

   Why is the ability to shift the burden the key distinction between direct and indirect taxes?

   Model answer

   With a direct tax the incidence is fixed by law on the person assessed, so an employee cannot pass income tax to anyone else. With an indirect tax the firm that hands over the money can respond by raising the selling price, so part of the burden lands on the consumer and only the remainder is absorbed by the producer. How the burden splits is an economic outcome determined by elasticities, not something the government can simply choose.

4. 4

   Classify each of the following as direct or indirect: value added tax, corporation tax, fuel duty, inheritance tax, national insurance, air passenger duty.

   Model answer

   Value added tax, fuel duty and air passenger duty are indirect taxes, because each is charged on a transaction and collected by the supplier. Corporation tax, inheritance tax and national insurance are direct taxes, because each is charged on profit, wealth or income and is paid by the person or firm assessed. The test in each case is whether the tax is levied on what someone earns or owns, or on what they buy.

5. 5

   Explain the difference between a specific and an ad valorem indirect tax, and describe how each affects the supply curve on a diagram with price on the vertical axis and quantity on the horizontal axis.

   Model answer

   A specific tax is a fixed sum per unit sold, such as a set amount of duty on each litre of fuel, while an ad valorem tax is a percentage of the selling price, such as value added tax at 20%. On a diagram with price on the vertical axis and quantity on the horizontal axis, a specific tax shifts the supply curve vertically upwards by the same cash amount at every quantity, so the new supply curve is parallel to the original. An ad valorem tax shifts supply upwards by a proportion of price, so the gap between the two curves widens as price rises and the new supply curve pivots away from the old one, being further above it on expensive units than on cheap ones.

6. 6

   A specific duty of 4 pounds per bottle is added to wine. Calculate the duty as a percentage of the final shelf price for a bottle with a pre-duty price of 6 pounds and for one with a pre-duty price of 26 pounds, and explain what this shows about specific duties.

   Model answer

   The cheap bottle sells for 6 plus 4 = 10 pounds, so the duty is 4 divided by 10 = 40% of the shelf price. The premium bottle sells for 26 plus 4 = 30 pounds, so the duty is 4 divided by 30 = 0.133, or 13.3% of the shelf price. Because the same cash amount is a much larger proportion of a cheap product, a specific duty bears more heavily on buyers of low-priced brands, who tend to be poorer, which makes it regressive in effect.

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