Taxes are an important means for revenue collection by governments across the world. Taxes are important as they contribute greatly towards the public exchequer and help the government meet its expenses and funds it various programs.
This article looks at meaning of and differences between two different types of taxes based on how they are levied – Direct taxes and Indirect taxes.
Definitions and meanings
Direct taxes are taxes wherein the levy of tax and liability to pay tax falls on the same entity. Direct taxes are paid directly to the government by the income earning individual/entity. The burden of payment cannot be transferred by the individual/entity on which it is levied to any other individual or entity.
These are generally imposed on individuals/entities or property. Examples of direct taxes include income tax which is levied on income earned by individuals and entities and wealth tax which is imposed on assets held by individuals and entities.
Levy of direct taxes have several benefits including:
- Controlling inflation – direct taxes reduce surplus cash in the hands of individuals, which in turn can reduce demand for goods and services and curb inflation
- Income balancing and distribution – direct taxes are generally levied on staggered basis increasing with an individual/entities’ increasing income. These taxes are used for societal expenses. This can bring some amount of income balancing in society
Indirect taxes are taxes wherein the levy of tax is on one entity and the liability to pay the tax falls on another entity.
These are generally imposed on the occurrence of certain transactions involving goods and services. Indirect taxes are collected and remitted to the government by one entity in the value chain but it is ultimately passed on to the consumer by including the same in the price of the product of service. In this way, the burden of payment of indirect taxes can be shifted from one entity to another.
Examples of indirect taxes include excise duty imposed on manufacture of goods, sales tax imposed on sale of goods and services, customs duties imposed on import and export of goods and services etc.
As indirect taxes are levied on goods and services and not on incomes they are borne equally by all consumers without differentiating between higher income and lower income consumers.
Difference between direct taxes and indirect taxes:
The major points of difference between direct taxes and indirect taxes have been detailed below:
- Direct taxes are taxes in which the charge of tax and its payment liability falls on the same entity.
- Indirect taxes are taxes in which the charge of tax is on one entity but its payment liability falls on another entity.
2. Taxed entity and incident
- Direct taxes are levied on individuals and entities, on their incomes and properties.
- Indirect taxes are levied on the good and services transactions – such as on the manufacture and sale of goods and services.
- In direct taxes, the taxpayer is the income earning individual/entity on which the tax is levied.
- In indirect taxes, the taxpayer is generally the ultimate consumer of the goods and services and not the manufacturer or service provider on whom they are levied.
4. Transfer of burden
- Burden of payment of direct taxes cannot be transferred by the individual or entity on which it is levied.
- Burden of payment of indirect taxes can be transferred from one entity to another.
- Direct taxes are collected only from individuals/entities earning income over certain amounts; it is thus applicable on a smaller scale at a micro level.
- Indirect taxes are collected across all goods and services consumed and are thus applicable on a larger scale at a macro level.
- Direct taxes have the effect of reducing available cash surplus with the income earning individual/entity.
- Indirect taxes have the effect of increasing the cost of products and services on which they are levied.
7. Difference in taxation levels
- Direct taxes are levied based on income levels of the individual/entity, charged at higher rates on higher income levels.
- Indirect taxes are levied on goods and services consumed by both high level and low level income groups. Hence, its burden falls uniformly on all income level consumers.
8. Social impact
- Direct taxes seek to reduce income inequalities and are thus considered to be progressive in nature.
- Indirect taxes are levied uniformly on the rich and poor consumers and are thus considered regressive.
9. Chances of evasion
- Direct taxes can be more easily evaded by manipulating the declared income earned.
- Indirect taxes are tougher to evade as they are included in the price of goods and services that are purchased by consumers.
- Direct taxes include income taxes and wealth taxes.
- Indirect taxes include excise duty, sales tax, value added taxes and custom duties.
Direct taxes versus Indirect taxes – tabular comparison
A tabular comparison of direct taxes and indirect taxes is given below:
|Taxes which levies the charge of tax and liability to pay it on the same entity||Taxes which levies the charge of tax and liability to pay it on different entities|
|Taxed entity and incident|
|On individuals/entities with respect to their incomes and properties||On the transactions pertaining to exchange of goods and services|
|Individual/entity who has earned the income||Ultimate consumer of the goods or services|
|Transfer of burden|
|Smaller scale, micro level||Larger scale, macro level|
|Reduction of available cash flow leading to reduction in demand for goods and services and reducing inflation||Increase in costs of effected goods and services|
|Difference in taxation levels|
|Directly proportionate to income levels||Uniformly levied on all|
|Progressive in nature||Regressive in nature|
|Chances of evasion|
|Higher chances||Lower chances|
|Income tax and wealth tax||Goods and service tax, Excise duty, value added tax, customs duty|
Both direct and indirect taxes are important to generate revenue from a government’s standpoint. Direct taxes can be utilized by governments to tax the rich and serve the poor. Indirect taxes can be increased on harmful products such as cigarettes and tobacco to discourage their consumption in society. Thus both these taxes play important role from a societal context as well.