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Skip to 0 minutes and 13 seconds This is a complex question. Direct taxes are levied on personal income and wealth and corporate profits. And the burden of such taxes, that is, who actually pays the tax, cannot be shifted. Indirect taxes, such as VAT or sales tax, excise duties on commodities like alcohol, tobacco and petrol, can be shifted, in that while the tax is levied on a company such as a retailer, the retailer can pass on the burden by raising the price at which they sell the product or service. Direct taxes can be progressive, that is higher rates of the tax could be levied on those with higher incomes or greater wealth. This fits in with the notion of fairness and the ability to pay.

Skip to 0 minutes and 59 seconds However, if rates are high, then arguably such taxes may produce the distortionary effects mentioned earlier, and this may be harmful to economic growth. High rates may also encourage tax evasion, that is illegally avoiding paying taxes, or tax avoidance, that is legally avoiding taxes by arranging one’s affairs so as to minimise the amount of tax paid. Indirect taxes arguably have lower distortionary effects, as they tax spending, which can be discretionary rather than income or wealth. Indirect taxes are also more difficult to evade or avoid, such as in the example of smuggling. The main criticism of such taxes is that they can be regressive, that is they take more from the less well-off than those who are better off.

Skip to 1 minute and 47 seconds This would be the case with the 10% VAT rate. This represents a bigger proportion to a person with a lower income than it would for a higher income earner. Governments can soften this regressive aspect by exempting some categories from such a tax, for example, food, or having multiple rates, such as lower rates for necessities and higher rates for luxury goods and services. This makes the tax more complex and administratively more difficult to collect. Poorer countries often have much smaller formal economies than the more developed countries, since there’s a significant amount of self-sufficient agriculture and other rural activities. This reduces the tax base to mainly urban activities and large companies.

Skip to 2 minutes and 34 seconds In the past, such countries relied on taxes on international trade for their main source of revenues. But as tariff barriers have been reduced and eliminated by successive rounds of free trade agreements, these countries have had to search for alternative tax bases. Since reported income is low, this has meant an emphasis on indirect taxes on domestic spending.

Should governments prefer direct or indirect taxation?

Should taxation be targeted at earnings and wealth, or spending? What are the advantages of direct taxes over indirect taxes, and do these apply in all economies?

Professor Tony Allan presents the arguments for where the burden of taxation should fall.

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This video is from the free online course:

Understanding Public Financial Management: How Is Your Money Spent?

SOAS University of London