Indirect Taxes Aren't Worth the Trouble

A common proposal is to increase the usage of indirect taxes in the economy. As opposed to direct taxes, such as the income tax, indirect taxes are taxes on consumption — taxes factored into the prices of goods and services. The Value Added Tax (VAT), sales tax, service tax, etc., are all indirect taxes.

At first glance, the proposal has some merit. Indirect taxes mean that if a rich chap decides to buy a yacht, he has to pay more than a beggar buying some rice.

This, of course, assumes that the indirect tax is an ad valorem tax, i.e., the tax is proportional to the price of the good or service. (Most indirect taxes, which are a percentage of the price, are ad valorem taxes.) Were the tax to be a lump sum tax, it would be a whole different ball game.

It is often argued that indirect taxes are more equitable and just, because they tax you based on how much you consume. If you consume more, you pay more, and if you consume less, you pay less. It's simple.

The trouble often is that people don't think through the consequences of an indirect tax. For those who aren't aware, there are two main kinds of taxes — regressive and progressive taxes. Progressive taxes are taxes that take away a greater proportion of the taxpayer's income as the tax bracket rises. Regressive taxes, however, reduce the proportion of taxes relative to gross income as the tax bracket rises.

Which category do indirect taxes fall into, assuming we implement a single indirect tax on all goods and services for reasons of simplicity? I argue that indirect taxes are clearly regressive taxes.

After all, let's return to the beggar buying rice. He spends a lot of his income simply to stay alive, to eat — in economic jargon, he has a very high marginal propensity to consume.

The millionaire yacht-buyer, however, has far too much income to spend on consuming. In the first place, if he was wise enough to become a millionaire, he would be investing and/or saving a lot of his money rather than consuming it. (There's a reason artifically-created millionaires, such as those who win the lottery or inherit their wealth, spend their riches away so quickly.) His marginal propensity to consume is low.

In other words, a much higher proportion of the beggar's income is spent on consumption than the millionaire's income. If you tax consumption, then the beggar will be paying proportionally more tax. This is an instance of regressive taxation.

You might argue for a flat tax rate — when I was young and foolish, I was a sturdy proponent of such an idea, although I am no longer so strongly convinced of its merits. But few would support a regressive tax that hurts the poor more than it hurts the rich.

There is obviously some merit in indirect taxation, as otherwise it would not be a common feature of so many economies. But proposals to vastly extend its reach are, I think, misplaced. If we want to raise more government revenue or create a more equitable society, there are better alternatives than a regressive taxation system such as one based on indirect taxes.