INDIRECT TAX SYSTEM: INTRODUCTION
Taxation – Lecture 5
Content
• Taxation of spending – background and state in OECD and EU
• Do consumption taxes harm work incentives less?
• Tax policy: the future
• Literature
Taxation of spending
• Indirect taxes or taxes on spending are those on turnover,
production or consumption of goods and services - regarded as
components of cost prices and selling prices - which are
collected without regard to the realization of profits, or indeed
income, but which are deductible when determining profits. In
most countries, taxes on spending include most or all items of
consumer spending, and also some additional taxes, or excise
duties, on certain individual categories of spending, especially motor
fuels, motor vehicles, alcoholic drinks, and tobacco products.
• Indirect taxes are collected by an intermediary (such as a retail
store) from the person who bears the ultimate economic burden
of the tax, that is, ultimate consumer. It does not respect the
personal situation of the consumer.
• Four trends that shape the global indirect tax landscape today:
 Indirect taxes continues to grow, while direct taxes
stagnate.
Taxation of spending
 Indirect taxes are adapting to the new economic realities.
(E-commerce and virtual currencies are on the radar of an
increasing number of governments, and they are adapting their
tax systems to capture these transactions.)
 The global trade landscape is changing fast. (Global trade
continues to grow, but still faces trade restrictive measures in
many regions of the world.)
 Tax authorities are focusing on enforcement of indirect
taxes. (New tools and rules are simplifying tax authorities’
access to taxpayer data and increasing the frequency,
efficiency and effectiveness of tax audits.)
Taxation of spending
Taxation of spending - VAT
• In nearly all OECD countries the general tax on spending takes
the form of a VAT:
Taxation of spending - VAT
• VAT was introduced in France in the 1950s, and adopted by the
member countries of the European Community in the late 1960s.
It has been one of the great success stories of tax policy in recent
years, having now been adopted, in one form or another, by all of
the major OECD countries with the exception of the USA, and by
many developing countries too.
• VAT is levied as a percentage of the value of sales of most goods
and services by all forms of business, though in some countries
there are exemptions for smaller firms, simply to avoid costs that
would be incurred in collecting trivial amounts of tax revenue from a
very large number of very small firms. The distinctive feature of VAT
is that it generally applies without distinction to sales made to all
categories of customers, including sales made to other
businesses as well as retail sales to individual consumers.
However, businesses which have purchased goods and services
from other firms can offset the tax they have paid on these
Taxation of spending - VAT
purchases against their VAT bill on their own sales.
• If VAT is a tax on the value of sales, why then is it called a ‘value
added’ tax? The reason can be seen by considering how the tax
accumulates during the course of the production chain - as raw
materials are gradually transformed into processed materials,
components, and then into final products sold to consumers. If the
same rate of tax is charged on all sales and purchases, the additional
tax collected at each stage of production will be proportional to the
value added by that firm: in other words, proportional to the
difference between the value of the material and components it
buys, and the value of the products it sells.
• In practice, most VAT systems have different rates of tax for
different categories of goods. Most of the member states of the
European Union, for example, have a ‘standard’ rate of VAT,
applying to most goods and services, and one or more ‘reduced’
rates, applying to particular categories of consumer spending,
Taxation of spending - VAT
including food, household energy, books, and newspapers:
 In France the standard rate in 2014 was 20 per cent. A
reduced rate of 10 per cent applied to public transport,
hotels and restaurants, and cultural and sporting events,
while food, water, and books were subject to VAT at 5.5 per
cent, and newspapers were taxed at 2.1 per cent.
 Denmark, by contrast, is distinctive in having a single VAT
rate. It applies its standard rate of VAT, 25 per cent to all
goods and services.
Taxation of spending – excise duties
• Excise duties were historically one of the main revenue-raising
taxes, but have declined in importance over the past century as
more modern and powerful sales taxes have been introduced.
Even now, excise duties and taxes on imported goods remain crucial
for the revenues of many developing countries, where the
organization of economic activity and the limited capacity of
government may make complex accounts-based taxes unfeasible.
• Excise duties are now confined in most developed countries to a
small number of products, including motor fuels, vehicles,
alcoholic drinks, and tobacco products. In many countries, some
or all of these products are taxed at very high levels indeed. For
example, in the UK, the taxes charged on cigarettes, including VAT
and the excise duty, account for around 80 per cent of the retail
price, while the taxes on petrol amount to nearly 60 per cent of its
retail price.
• Such high rates of tax require tight control, of the production
Taxation of spending – excise duties
and distribution of the commodities concerned, if massive tax
evasion is not to take place. Generally, excise duties are levied at
a relatively early stage in the chain of production and
distribution to keep to a minimum the number of businesses
involved. It is much easier to charge high levels of tax on whisky by
taxing the distiller than it would be to charge similar tax rates at the
point of retail sale. Similarly, the high excise duties charged on motor
fuels are levied on the major producers, refiners, and importers,
and the fuel is only released for distribution and retail sale once
the tax has been charged. Nevertheless, while it is relatively
straightforward to ensure that large brewers, cigarette manufacturers,
and petrol companies are monitored and taxed correctly, the high
levels of excise duty can provoke various forms of smuggling,
cross-border shopping, and bootleg production. This has
become a worrying headache for some revenue authorities in
Europe, as border controls have been removed to allow a free
flow of trade between the EU member states.
Taxation of spending – environmental taxes
• A growing awareness of environmental issues has led many
countries to introduce tax measures to discourage pollution and
environmental damage. Existing taxes, such as those on carbonbased
fuels and motor vehicles, have been increased or
restructured to discourage the most polluting activities or stimulate the
take-up of greener alternatives. In addition, new taxes have been
introduced specifically to address particular environmental problems for
example the UK’s Landfill Tax on waste dumps, introduced in 1996
with the aim of encouraging greater recycling.
Taxation of spending – import duties
• There is one area of taxation which has declined sharply over the
last half century, especially in the industrialized world. Tariffs on
international trade - taxes on imported goods - have been
reduced to very low levels as a result of the successive rounds
of multilateral tariff reductions agreed under the auspices of the
World Trade Organization (WTO), and its predecessor, the
General Agreement on Tariffs and Trade (GATT). In the United
States and in the EU the revenue from tariffs is now only about 1
per cent of the revenue from other taxes. Elsewhere, however, and
especially in less developed countries, the significance of tariff
revenues can be much greater. For countries with limited
administrative capacity, frontier formalities provide one of the
few reliable points at which taxes can be charged, and import
taxes can make a significant and secure contribution to public
revenues. In many countries in Africa, tariffs contribute 20 per cent or
more of total tax revenues.
Do consumption taxes harm work incentives
less?
• It is sometimes suggested that damage done to work incentives
by high taxes on labor incomes could be reduced by shifting
revenue-raising away from income taxes towards consumption
taxes such as VAT. Certainly, VAT has considerable revenue-raising
potential, and the revenues it raises could give scope for a substantial
reduction in income taxes on wages. But the idea that this shift in
the pattern of taxation avoids the distortionary effects of taxes in
the labor market is simply mistaken. Taxes levied on spending
reduce the quantity of goods and services that can be purchased
from the proceeds of an additional hour’s work in just the same
way as a tax on income does.
• How much more do consumption taxes add to the burden of tax on
labour incomes? In particular, how much do they add to the marginal
tax rate? The answer is not straightforward since it depends on how
individual consumption patterns change as workers earn
additional income. However, figures for 2005 from the OECD
Do consumption taxes harm work incentives
less?
indicate that consumption taxes on average added a further 6.7
per cent to the tax wedge on earnings, raising the overall tax
wedge in OECD countries from an average of 38.6 per cent to
45.3 per cent.
• While the distortionary impact on the labor market of raising a
given amount of revenue through an increase in the marginal
rate of income tax and an increase in the rate of VAT may be
similar, there are two differences of some significance between
income tax and a sales tax such as VAT:
 The first is that they affect the interests of different
generations differently. Switching from a tax on income to
a tax on spending acts to disadvantage older generations
relative to younger generations - in particular, the retired who
have saved out of taxed income face an increased tax burden
on their spending, while for younger generations the tax
change makes little difference.
Do consumption taxes harm work incentives
less? The second difference arises when the income tax has a
progressive distributional incidence - for example, when
the income tax schedule begins with a significant
allowance of tax-free income. As a result, the marginal rate
of income tax (which governs the amount of distortion) tends
to be much higher than the average rate of income tax
(which determines the amount of revenue raised). Sales taxes,
by contrast, tend to apply to all consumption and imply
lower marginal rates for a given amount of revenue. As a
result, an equal revenue switch from income tax to VAT
can reduce the overall marginal tax wedge on earnings. It
does so only because the tax on spending is less
progressive than the income tax, and therefore marginal
tax rates are lower. Proposals to shift from income tax to
VAT achieve a reduction in the overall marginal tax wedge
by making the tax system less redistributive, a feature that
is rarely stated explicitly by those advocating such a tax
shift.
Indirect tax policies - the future
• At the start of this course we saw the massive expansion in tax
revenues over the past fifty years. Over the OECD area as a
whole, tax revenues increased more than fourfold in real terms,
as economic growth led to higher revenues, and more tax was
raised through higher social contributions and the introduction
of VAT. At the same time, the revenues from taxes on
international trade fell as the result of successive rounds of
trade liberalization. What changes might we expect to see in the
coming decades?
• The most powerful force shaping future tax policy is likely to be the
increasing globalization of economic activity, which means that
countries’ economies will be closely interconnected, and their
economic policies - including tax policies - increasingly
constrained by the pressures of international economic
competition. Policy choices in other countries will severely limit
the margin for manoeuvre in domestic tax policy.
Indirect tax policies - the future
Globalization has made tax bases more mobile. Capital and
investment, the production of goods and services, and, indeed,
employment can move much more freely between countries, and
decisions about where to invest and produce are likely to be
increasingly influenced by taxation. The effect of this increased
mobility is that countries will lose - and indeed have already lost substantial
de facto fiscal sovereignty. Countries that try to set
tax rates for capital or other highly mobile tax bases that are
higher than the tax rates elsewhere will find that they lose tax
base to their competitors as mobile activities move abroad. In
markets such as capital markets with a high level of international
integration, countries may have negligible power to set tax rates
that differ from the rates ruling elsewhere; if they were to do so
they would suffer a substantial capital outflow, which would
continue until the net of tax return available to the investor was
equalized with the net of tax return available in other locations. It
Indirect tax policies - the future
is this process that is already thought to have shifted much of the
burden of corporate taxes in smaller economies away from
capital and onto less mobile tax bases such as unskilled labor.
Countries that try to have a tax system that is more redistributive
than elsewhere may find that the losers from this redistribution
move elsewhere, leaving only those who might have expected to
gain. Some pessimists see in this process the end of redistributive
public policy altogether, and the end of the welfare state. Even if this
exaggerates the severity of the constraint that international
competition places on redistributive policies, the reality is that
countries’ fiscal choices will be increasingly constrained by
competitive pressures. Highly redistributive policies will carry a
significant cost in the form of outflows of highly skilled labor and
capital, which will increase the cost of redistribution.
• The pressures on tax policy from the effects of greater mobility
of commodities, firms, and people in the globalized economy will
Indirect tax policies - the future
be exacerbated by the impact of the internet, which is already
reshaping certain areas of the economy, and which creates new
difficulties for tax systems which are, in the main, designed to deal
with transactions in physical goods. Internet-based retailers have
proved adept at exploiting opportunities to have their products taxed
in countries offering them the most favourable tax regime, both for the
taxes they must charge on sales, and the corporate taxes levied on
their profits. Some of the opportunities that internet-based
companies have been able to exploit to reduce the taxes charged
on their sales and profits are loopholes that have been exposed
in legislation which was not drafted with the internet in mind,
and, over time, many of these loopholes are likely to be closed.
However, while the internet may not - as some have feared - spell
complete catastrophe for the tax system, it has undoubtedly
amplified the impact of globalization on the fiscal system by
reducing the costs of mobility and expanding the range of
activities that can be shifted to locations offering a more
favourable tax treatment.
Indirect tax policies - the future
• Unlike economic competition between firms, which tends to
promote efficiency and lower prices to consumers, fiscal
competition between countries is not a benign process. Tax
havens, in particular, exploit their ability to offer a lower tax
regime which undercuts the rates of tax elsewhere; they are not
offering any greater efficiency or any other positive advantage, but
only the opportunity to sidestep taxes levied elsewhere. Countries
which compete to grab tax base from other countries impose a
costly burden on other countries, raising their cost of revenueraising
and limiting the range of tax policy choices that countries
can make.
• A further aspect of globalization is the growing significance and
power of large scale multinational enterprises operating on a
transnational basis. Multinationals have the opportunity to shift
a significant proportion of their profits into countries where they
will be taxed less heavily by manipulating the internal charges -
Indirect tax policies - the future
the ‘transfer prices’ - at which they book trades between their
subsidiaries located in different countries. Profits can be shifted out
of a country where they would be taxed heavily by raising the
price which that subsidiary must pay other parts of the group for
supplies or the use of intellectual property, such as patents or
brand rights, and by undercharging for its own sales within the
group. The ‘arm’s length’ principle espoused by the OECD is
intended to constrain this, by forcing firms to set their internal
charging on a basis that mirrors the prices that would be charged for
an equivalent transaction between wholly independent firms. But it is
often very difficult to implement this principle, since there may
be no directly equivalent arm’s length transactions to use as a
benchmark. This is a particular problem with multinationals which
earn a substantial proportion of their profits from a brand image
or other special advantage that they possess. Such firms have a
considerable degree of latitude in shifting profits to lower tax countries
and tax havens. At the very least, the grey area around transfer
Indirect tax policies - the future
pricing offers considerable scope for firms to challenge the tax
assessments they receive, and the tax authorities must then decide
whether to spend resources on a legal battle to preserve their
revenues.
• One way of restoring some measure of tax sovereignty is,
paradoxically, through international coordination and
harmonization. If countries collectively agree ground rules that
limit the scope for tax competition that could drive tax rates
downwards, all may benefit by being able to raise revenues
without the erosion of those tax bases most affected by mobility.
There is nothing equitable about a tax system in which the
mobile - and perhaps predominantly rich - can avoid taxation,
while the burden of taxation ends up borne by those unable to
escape. Nor is there anything efficient about allowing
unrestricted international tax competition to erode parts of the
tax base. A continuing feature of tax policy over the coming years is
Indirect tax policies - the future
likely to be a difficult and protracted international debate over
whether countries are willing to reach some form of agreement
to limit the scope for tax competition and the operation of
international tax havens.
Literature
• MCGEE, Robert W. The philosophy of taxation and public finance.
Boston: Kluwer Academic Publishers, 2004. viii, 313.
ISBN 1402077165.
• RADVAN, Michal. Czech Tax Law - 3rd ed. 3. vyd. Brno: Masarykova
univerzita, 2010. 65 s. Fac. of Law Publ. no. 4 (Edition of textbooks).
ISBN 978-80-210-5269-7.
• SMITH, Stephen. Taxation: A Very Short Introduction. Oxford
University Press, 2015.
• Taxation trends in the European Union 2014: Data for the EU Member
States, Iceland and Norway. Taxation and Customs Union: Eurostat
Statistical books, 2014 edition. ISSN 1831-8789.