Governments can use many types of taxes to meet their revenue needs. Two of the main types of taxes are direct taxes and indirect taxes. The difference between direct and indirect tax is that the former is levied directly on citizens, while the latter is imposed on producers of goods and services. While indirect tax is imposed on producers, it is generally passed on to consumers.
Most countries rely on a mix of direct and indirect taxes to raise revenues. The mix will depend on the government’s priorities and also its ideological leanings. So, it’s important to understand the difference between direct tax and indirect tax. For instance, a conservative government will favour indirect taxes than direct taxes. This is because it is felt that a direct tax on income could act as a disincentive to individual effort and enterprise, and thus hamper economic growth. A more left-leaning government many feel that indirect taxes are regressive and put a disproportionately higher burden on poorer people. So, let’s look at the difference between direct and indirect tax, and the various pros and cons.
|Direct Tax||Indirect Tax|
|These include taxes like income tax, corporate tax, wealth tax, capital gains tax etc.||Taxes include Goods and Services Tax (GST), excise duty and customs duty|
|Levied directly on individuals or organisations||Imposed on the producers of goods and services|
|Burden cannot be shifted elsewhere||Producers can shift the burden of indirect tax on to consumers. The extent will depend on the elasticity of demand. If demand is inelastic, producers can pass on the entire burden|
|Considered a progressive tax and for the most part higher the income, higher the percentage of tax paid||Considered regressive since taxes are imposed on all without distinction. Of course, luxury goods can be taxed more|
|Evasion is easier since it’s harder for tax authorities to keep track of individual incomes||Evasion is difficult since taxes are imposed on producers. It’s easier to keep track of producers since they are fewer in number|
|Higher administrative costs since it takes much more effort to monitor individual taxpayers||Administrative costs are lower since fewer taxpayers need to be monitored|
|Cannot be used to influence consumption of certain products||High taxes can be used to dissuade people from consuming certain products, like cigarettes and alcohol. Low taxes can be used to encourage production and consumption of other products|
|Taxable pool of people is quite small, especially in a country like India, where only about 2 percent pay income tax||A much wider pool of people can be brought under the tax net, by taxing commonly used commodities like soap|
|Can help control inflation, since the tax will directly affect incomes and thus consumption||Indirect tax may actually raise the inflation rate by increasing prices of various goods and services|
|Critics say direct taxes act as a disincentive to private initiative, thus lowering economic growth rates||Do not act as a disincentive to growth, unless commodities are imposed punitive levels of tax|
Now that we know what the difference between direct tax and indirect tax is, let’s look at some of these.
This is a tax on the income of an individual. It is generally a progressive tax – that is, higher the income, higher the percentage of tax. It also tends to be unpopular among taxpayers because its effect is direct and immediate. The sight of a big chunk of your income eaten away by tax is enough to send the blood pressure shoots through the roof! No wonder then governments are keeping income tax rates on the lower side.
Income tax can be levied on income from profession or business, property or house, salaries, capital gains and other sources. The tax you have to pay depends on your income slab. Senior citizens are eligible for lower rates.
However, taxpayers can reduce the burden of income tax by investing in certain specified instruments. For example, you can reduce taxable income by Rs 1.5 lakh by investing in certain instruments under Section 80C of the income tax act. These include equity linked savings schemes (ELSS), Public Provident Fund (PPF), National Savings Certificates (NSC) etc.
Among the different types of direct taxes, corporate tax contributes the most to the government’s coffers. Corporate tax is imposed on the profits made from business activity. In the past, corporate taxes used to be very high, almost punitive. But over the past few decades, governments have become much more business-friendly and have reduced these rates to encourage economic growth.
Income for the purposes of corporate tax include profits earned from the business, capital gains, income from property, income from renting property and from other sources like dividend, interest etc.
Companies with a gross turnover of up to Rs 250 crore have to pay 25 percent tax, while those whose turnover exceeds Rs 250 crore have to pay 30 percent, as of AY 2019-20. Companies are allowed various deductions like expenses and so on. There is also an investment allowance for new plant and machinery. However, all companies have to pay a minimum alternative tax (MAT) of 18.5 percent of book profits.
Capital gains tax
Another type of direct tax is capital gains tax, which can be imposed on individuals as well as companies. Capital gains are made when an asset is sold for a profit. These assets can include equity, mutual funds, land, apartments, offices, etc. There are two types of capital gains tax – long-term capital gains (LTCG) tax and short term capital gains (STCG) tax. These can be imposed on various asset classes like equity, debt, mutual funds, housing, land etc.
Securities transaction tax
This is a type of direct tax imposed on transactions conducted on the stock exchange. Trading in equities, futures and options is taxed, and taxes vary from 0.017 percent to 0.25 percent. This tax will increase the cost of transactions.
Not many people are aware of this, but there is an expenditure tax in India. Under the Expenditure Tax of 1987, expenses on hotel rooms and restaurants above a certain limit are subject to a tax.
Goods and services tax (GST)
In order to reduce different types of indirect tax and makes things easier for taxpayers, the government introduced uniform GST for various goods and services across the country. While the same rates apply all over the country, different goods and services are charged differently. There are five slabs currently, ranging from 0 percent to 28 percent.
Tax rates are fixed by the GST council, which is headed by the Union finance minister. Members include finance ministers from all the states. Some governments prefer indirect taxes since they do not hit citizens directly, and so causes less outrage when rates are increased. However, indirect taxes tend to be regressive.
Though most indirect taxes now come under the GST umbrella, there are some exceptions. This has been made to benefit the states, to which excise revenues accrue. Some of the products that come under the excise umbrella are liquor for human consumption and petroleum products.