A Guide to Understanding Indirect and Direct Taxes
Difference between direct and indirect tax
John Stuart Mill gave the following definition: “A direct tax is one which is demanded from the very persons who it is intended or desired should pay it. Indirect taxes are those which are demanded from one person in the expectation and intention that he shall indemnify himself at the expense of another.”
The distinguishing feature may therefore be said to be whether the taxpayer is or is not the person on whom the economic burden of the tax is expected to fall. In this respect, a tax may be said to be direct either in the sense of assessment or collection. Thus, income tax is generally assessed directly on the taxpayer but collection is becoming increasingly indirect (e.g. by way of withholding).
An important distinguishing feature of direct taxes is sometimes said to be their capacity to take into account the circumstances of individual taxpayers. This suggests there may also be a relation between indirect taxes and “in rem” taxes, the latter not generally taking into account personal circumstances.
Another approach (adopted by the United Nations in its System of National Accounts) bases the distinction on whether the tax is levied at regular intervals on sources of income such as employment or property (direct taxes), or on producers in respect of the production, sale, etc. of goods and services, which they charge to the expenses of production (indirect taxes).
A commonly accepted (if not comprehensive) distinction may be made on the basis of whether the tax is a tax on income - including capital gains and net worth - (direct) or on consumption (indirect). Indirect taxes are considered to be one of the oldest sources of government revenue.
Indirect taxes are generally imposed on and collected from a person or company engaged in a consumer facing business, i.e. business-to-consumer (B to C), such as a retailer or vendor, but the economic burden of the tax is shifted to another person or company, typically the consumer of the good or service.
Indirect taxes can also be imposed in a business-to-business context (B to B), but as with other indirect taxes, the ultimate economic burden will be passed on to the ultimate consumer of the good or service.
Direct taxes, on the other hand, are imposed on and collected from the taxpayer with the legal obligation to pay the tax and cannot normally be shifted to another person.
Breaking down direct taxes
At their core, direct taxes are levied directly upon individuals (ie a personal income tax), corporations (ie a corporate income tax), or other entities (e.g.: pass-through entities tax, estates and trust taxes etc.) by tax authorities. They are paid directly to the government, and critically, the entity that pays the tax is the one that bears the fiscal burden. These taxes are non-transferable and represent a significant portion of tax revenue for many nations. Examples include:
- Income taxes: Perhaps the most immediate taxes that come to mind for many individuals. Whether it's federal income taxes or state-based, these are levied based on the earnings of an individual or corporation. Within this category, we also encounter the capital gains tax, applied to profits from the sale of investments or property.
- Property taxes: Charged based on the value of owned property, these can be applied to both real estate and personal property, such as vehicles.
- Estate and gift taxes: Designed to tax wealth transfers, they apply to property transferred upon death (estate tax) or gifts given during one's lifetime (gift tax).
The levying of direct taxes, especially progressive income taxes, often serves dual purposes. First, it's a primary revenue source. Second, it can be a mechanism to address income inequality, with higher income brackets facing higher tax rates.
Breaking down indirect taxes
Unlike their direct counterparts, indirect taxes are levied on goods and services. While businesses might pay these taxes directly to the government, they often factor these costs into the prices of goods or services, effectively passing the tax burden to the consumer. Therefore, while consumers don't pay these taxes directly to the government, they feel the impact in the form of higher prices. Examples include:
- Value Added Tax (VAT) or Goods and Services Tax (GST): Applied at various production stages, these taxes accumulate throughout the product or service lifecycle. While VAT is more common in European countries, the GST system is gaining traction in regions like Asia, specifically in countries like India where it has unified multiple taxes into one.
- Sales taxes: These are straightforward – a percentage added to the retail price of a wide range of goods. They are common in many countries, including numerous U.S. states.
- Excise taxes and duties: These are more specific and can be seen as luxury or sin taxes. They target goods like alcohol, tobacco, and fuel. Customs duty, on the other hand, is a charge on imported goods.
From an economic perspective, indirect taxes, particularly regressive ones like sales tax, can disproportionately affect lower-income individuals. They might spend a more significant portion of their earnings on taxed goods and services compared to higher-income individuals. Policymakers often have to juggle the advantages of revenue collection with potential societal impacts.
Direct vs. indirect taxes - Implications and intricacies
Economic burden and equality: As mentioned, direct taxes can be structured progressively, aiding in income redistribution. Indirect taxes, due to their broad application, can inadvertently burden those with lower incomes more heavily.
Adaptability and complexity: The structure of direct taxes can be tweaked to accommodate societal changes, economic downturns, or upturns. Indirect taxes, being broad-based, don't offer this flexibility, making them a steady, yet sometimes controversial, revenue stream.
Evasion and enforcement: Indirect taxes, being integrated into the purchase process, can be harder to evade, ensuring consistent revenue. Direct taxes, given their complexity and multiple avenues for deductions, can sometimes be prone to evasion or avoidance, requiring robust enforcement mechanisms by tax authorities.
Final notes on direct and indirect taxes
Taxation plays a fundamental role in how modern societies operate. Whether we're dealing with direct taxes during tax filing season or encountering indirect taxes in our everyday purchases, it's crucial to understand their impact. As individuals, businesses, or policymakers, a clear grasp of both direct and indirect taxes helps us make well-informed financial and legislative choices.