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Direct vs. indirect tax: the differences

February 6, 2024 · 9 minute read

Understand the differences between direct and indirect taxes, the several key types, and the importance of compliance for companies in an ever-changing industry.

Direct tax and indirect tax. You’ve likely heard these terms but understanding what they are and how they differ is important in helping companies better understand the costs they may face and how much they may owe going forward.

The differences between direct tax and indirect tax are important to understand. Direct tax is paid directly by the taxpayer to the government and cannot be shifted, like federal income tax. In contrast, indirect tax, such as business property taxes, can be passed on or shifted to others.

But it doesn’t end there. Like branches of a tree, there are various offshoots or types of taxes that exist beneath the overarching canopies of direct and indirect taxes. We’ll discuss those in more detail shortly.

Taxes are an important source of revenue for governments and properly determining and complying with taxes is obviously critical for taxpayers to avoid fees and penalties. So, it’s important that companies understand the different taxes to help ensure compliance. Here are the main differences between direct and indirect taxes:

Direct taxes

• Levied on people and entities  
• Are typically proportionate to the taxpayer’s income or assets
• Considered a progressive tax.
• Non-transferrable, the tax is borne by the taxpayer  
• Examples include income tax, corporate tax, and property tax

Indirect taxes

• Levied on goods and services  
• Are based on the value of the good or service
• Considered a regressive tax
• Transferrable, with consumers ultimately paying the tax. In the case of customs duties, excise taxes, and tariffs, the cost is embedded in the price of the product or service
• Examples include VAT, GST, customs duties, and tariffs

What is direct tax?

Direct tax is a tax levied on companies, as well as individuals, that cannot be passed on to another taxpayer. The taxpayer is liable for the tax payment, which is collected directly by the government.

Direct tax is progressive in nature. This means that the tax burden increases with income. In other words, an individual who makes a high income will pay a disproportionate share of the tax burden, while someone who makes a lower income will face a relatively small tax burden.

Direct tax may sound straightforward but it can get complex, so it can be beneficial to get direct tax software . For instance, companies may operate in multiple states, which makes it hard to keep track of each state’s apportioned tax .

Furthermore, time, accuracy, and efficiency are critical. Therefore, it is important to leverage robust tax provision software to speed up and automate the corporate financial close.

Direct tax can be broken down into five different buckets:

Individual income tax

Corporate income tax, capital gains tax, property tax.

Individual income tax, also known as personal income tax, is a tax imposed on the salaries, wages, investments, or other forms of income that a person or household earns.

This progressive tax is levied at the federal level, as well as in the majority of states.

The U.S. levies income tax rates that range and kick in at specific income thresholds. For example, for tax year 2023 , the top tax rate remained 37 percent for individual single taxpayers with incomes greater than $578,125 ($693,750 for married couples filing jointly). The lowest rate for tax year 2023 sat at 10 percent for incomes of single individuals with incomes of $11,000 or less ($22,000 for married couples filing jointly).

Incorporated businesses are taxed on their profits (minus allowable deductions), which is known as corporate income tax. The Tax Cuts and Jobs Act (TCJA) of 2017 reduced the federal corporate income tax rate from 35 percent to 21 percent.

Corporate income tax is a significant source of revenue for governments. In fact, it is the third-largest source of federal revenue, albeit smaller than individual income tax and payroll taxes.

C corporations are required to pay the corporate income tax, so it’s important to understand the tax provision and how to calculate it . However, pass-through entities — such as S corporations , sole proprietorships, LLCs , and partnerships — “pass” their income along to their owners. The owners include their allocated share of the businesses’ profits in their income tax return and pay the ordinary individual income tax.

In short, there are U.S. businesses that are not subject to the corporate income tax because they are taxed as “pass-through” entities.

Capital gains tax is a tax levied on the profit made from the sale of an asset, such as property and stocks.

Capital gains tax rates vary and that variance will depend on two factors: one’s income level and how long the asset was held. The latter refers to whether it is a short-term capital gain (held less than one year) or a long-term capital gain (held one year or more).

To further illustrate how capital gains tax works, consider the following example:

In 2018, you purchased 300 shares of “Company X” stock for $30,000. Three years later, in 2021, you sold those shares for $50,000. The long-term capital gain is $20,000 (which is subject to federal capital gains taxes and possibly state taxes as well, depending on where you live).

Estate tax is a tax levied on the net value of a person’s taxable estate (after any exclusions or credits) at the time of their death. The estate pays the tax before the assets are distributed to the heirs.

While there is both a federal estate tax and state estate tax, only 12 states and the District of Columbia levy an estate tax as of 2022.

Property tax is a tax imposed on both commercial and residential “real property” like buildings and land. It is also levied on tangible personal property such as inventories, business equipment, and vehicles.

Property taxes, which vary significantly among states and localities, are a critical source of revenue for state and local governments as they help fund roads, schools, police, and other services.

What is indirect tax?

Unlike direct tax, indirect tax is a tax that can be passed on to another entity or individual. Indirect taxes are levied on goods and services. The supplier or manufacturer passes on the tax to the consumer, who is the one ultimately paying the tax. The supplier or manufacturer collects the tax and then remits it to the government.

Indirect tax is regressive. This means the tax is applied uniformly irrespective of the income level of individuals. As a result, consumers with higher incomes will be paying a relatively small share of the tax, while low-income consumers will shoulder a disproportionate share.

Navigating the nuances of indirect tax can be challenging since there are always changes to indirect tax . Regardless of a company’s location or industry, leveraging indirect tax compliance , and also determination , software solutions that keep pace with the latest changes and complexities is critical.

There are four key types of indirect tax:

• Value-added tax (VAT)

Gross receipts tax

Sales tax is a consumption tax levied on the sale of goods and services. Once the tax is added to the sales price of a good or service, it is then charged by the retailer to the end consumer. The retailer then remits that collected tax to the government. Tax jurisdictions only receive tax revenue when a sale is made to the end consumer.

Sales tax varies by state and even local governments, which can quickly make sales tax confusing and difficult for companies to properly navigate.

Excise taxes, which are levied at federal, state, and local levels, are imposed on specific goods, like alcohol, tobacco, and fuel.

Companies often pay the excise tax and then pass the cost of the excise tax onto the consumer. Sometimes referred to as a “hidden tax,” excise taxes are typically not itemized on consumer receipts so these taxes are less visible to the consumer compared with clearly visible sales taxes and can be quite complicated to calculate .

Value-added tax

A value-added tax , also referred to as a VAT tax, is a tax on the value added at each stage of the supply chain in the production of goods and services.

How it works: Each business along the production chain pays a VAT on the value of the produced good or service at that stage. The business in each earlier stage of the production chain is then reimbursed for the VAT by the subsequent business in the chain. The end consumer is the one who ultimately pays the VAT tax.

For example, if a product costs $50 and there is a 10% VAT, the consumer pays $55 to the retailer. The retailer keeps $50 and remits $5 to the government.

Gross receipts tax, which is a tax on sales, is imposed on businesses and applies to business-to-business transactions. It is a tax businesses are required to pay on their gross receipts (i.e., gross sales, without deductions).

While gross receipts tax is imposed on the business, the cost of the gross receipts tax is often passed on to the consumer.

There are currently seven states that levy statewide gross receipts taxes: Delaware, Nevada, Ohio, Oregon, Tennessee, Texas, and Washington. The District of Columbia also levies a gross receipts tax on some industries. With the exception of Oregon and Ohio, each of these states uses different tax rates for different industries.

There’s no doubt that navigating the nuances and complexities of both direct tax and indirect tax is no small feat. Turn to a solutions provider like Thomson Reuters who can help you ensure compliance in today’s ever-changing business environment.

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• Key Differences

Know the Differences & Comparisons

Difference Between Direct Tax and Indirect Tax

What is a Tax?

Tax is a financial obligation, payable to the government for the cost of living in a society. It is a fee levied by the government of the respective country or territory on income, activities, goods, and services. It is broadly classified into direct tax and indirect tax.

Why Tax is imposed?

The main reason for imposing taxes is that they are the main source of government revenue. Revenue collected by the government is used for the purpose of providing public utility services like defense, education, infrastructure facilities, health care, etc. So, we can say that government imposes taxes to fulfill the socio-economic objective .

In this post, we will talk about the difference between direct tax and indirect tax.

Content: Direct tax Vs Indirect Tax

Comparison chart.

• Taxes Levied by Various Authorities
• Advantages and Disadvantages

Definition of Direct Tax

• Direct Taxes are the primary source of government revenue.
• It is progressive in nature i.e. it increases with an increase in income or wealth and vice versa.
• It operates on the notion of the ability to pay .

Meaning that it levies according to the paying capacity of a person. And so, the ones who earn more, pay more. In this way, the tax liability on the rich is more in comparison to the poor.

Also Read : Difference Between ITR-1 and ITR-4s

Definition of Indirect Tax

Indirect tax is one whose flow is not direct, i.e. implied, as it flows through others. When the taxpayer is the hands that deposit tax to the authorities, and at each stage, the incidence keeps on shifting until it reaches the ultimate consumer, who actually bears its burden, it is called an indirect tax.

These taxes are levied on the price of goods and services when they are produced and sold. So, it is the consumers who consume the product and bears the incidence at the end, but the immediate liability for the payment of tax falls upon the intermediary, i.e. manufacturer or retailer.

As it is not based on the principle of ability to pay , it is regressive in nature, as the burden of tax is borne by each class of people equally.

Do You know?

Previously, there are various indirect taxes that were imposed in India like excise duty, customs duty, service tax, sales tax, entertainment tax, purchase tax, luxury tax, etc. However, with the emergence of the Goods and Services Tax (GST), many indirect taxes were amalgamated into one. And only customs duty continues to levy even after the introduction of GST.

Stages of Imposition of Indirect Taxes

• Stage 1 – Levy : Those liable for tax are identified and charged.
• Stage 2 – Assessment : Process adopted for the ascertainment of indirect tax liability.
• Stage 3 – Collection : Tax collected by the Revenue department from the assessee.

Also Read : Difference Between Progressive Tax and Regressive Tax

Key Differences Between Direct Tax and Indirect Tax

As of now, we have discussed the basics of the two types of taxes, now we will move forward to understand the difference between direct tax and indirect tax:

• Direct Tax refers to the tax which is paid directly to the government by the person on whom it is imposed. On the other hand, Indirect tax is a form of tax that is paid by the taxpayer to the government, but the amount of tax is recovered from another person, who gets the benefits, i.e. the final consumer.
• The Central Board of Direct Taxes (CBDT) functioning under the Department of Revenue is the authority that administers Direct Taxes in India. Conversely, the Central Board of Indirect Taxes and Customs (CBIC) is the authority responsible for the administration of Indirect Taxes.
• While Direct tax is levied on the assessee, which may include Individual, HUF, Company, AOP, BOI, etc. Indirect Tax is paid by the final consumer.
• Direct Tax is progressive in nature, as it is based on the percept of ability to pay. So, the tax is imposed more on the rich and less on the poor. Oppositely, Indirect Tax is regressive in nature, as every person contributes equally to the payment of taxes.
• Direct Tax is one in which the incidence and impact of the tax fall on the same person, whereas Indirect tax is a tax in which the incidence and impact of the tax fall on different persons. Here incidence refers to the liability for the payment of tax, and impact means actual payment of tax.
• In the case of a direct tax, it is the taxpayer who bears its burden, i.e. it cannot be shifted to or recovered from another person. Conversely, in indirect taxes, the burden of tax can be shifted to another person.
• Direct taxes are when the assessee on whom the tax is imposed, is liable for its payment. Contrastingly, indirect taxes is when the person receiving the benefits is liable for its payment and not the person on whom it is imposed.
• Tax evasion is a practice of deliberately avoiding the payment of taxes while taking recourse to unlawful means . In the case of direct taxes, tax evasion is possible, whereas, in the case of indirect taxes, tax evasion is not possible as the amount of tax is hidden in the price of the goods and services itself.
• While direct taxes help in controlling inflation, by absorbing excess liquidity from the market, indirect taxes give rise to inflation or deflation.
• Direct taxes are imposed on and collected from assessees, which includes individuals, HUF, companies, etc. whereas indirect taxes are imposed on and collected from consumers of goods and services but paid and deposited by the assessee to the government.
• Direct tax is charged on individuals, HUF, and business entities, and the burden cannot be shifted to others. As against, Indirect tax is charged on commodities and services, and its burden can be shifted to others.
• The taxable event in the case of direct tax, when the income of the assessee reaches the maximum limit specified under the law, the exceeding amount will become taxable. Contrarily, whenever there is a purchase/sale/manufacture of goods and provision of services, it is a taxable event in the case of indirect taxes.
• Talking about administrative cost, the administrative cost of direct tax is greater in comparison to indirect taxes.

Video: Direct Vs Indirect Tax

Types of Direct Tax

Income Tax :

The tax imposed on the income earned by an assessee is called Income Tax. The rate of tax depends on the age and total earning during the previous year. For this purpose, the government introduced different tax slabs, and on the basis of those slabs, one can calculate the amount of tax he/she has to pay in the assessment year. And to do so, the assessee has to file Income Tax Return (ITR) for the concerned year.

Also Read : Difference Between Previous Year and Assessment Year

Wealth Tax :

Tax on the wealth of the assessee, determined by the property he/she owns and the market value of that property. The tax is paid annually, irrespective of the fact that if the property generates income for the individual or not.

Estate Tax :

Otherwise called inheritance tax, the tax has to be paid on the estate or money that a person has left for his/her family after he passed away.

Corporate Tax :

Domestic Companies and Foreign Companies (who earn income in India) are required to pay Corporate Tax. Further, it includes Securities Transaction Tax (STT), Dividend Distribution Tax (DDT), Fringe Benefits Tax, Minimum Alternate Tax (MAT), etc.

Capital Gains Tax :

Tax to be paid on the income earned on the sale of capital assets and investments. On the basis of the holding period, it is divided into – long-term and short term capital gain.

Also Read: Difference Between Short Term and Long Term Capital Gain

Types of Indirect Tax

Goods and Services Tax (GST) :

As the name suggests, GST is a single tax imposed on the supply of goods and services. Further, under the GST regime goods and services are treated equally for the purpose of imposition of taxes. The aim is to subsume various indirect taxes, imposed by Central and State Governments.

Also Read : Difference Between VAT and Service Tax

Customs Duty :

Customs Duty is imposed on the imports and exports of goods, at a specified rate. It is levied with an aim of reducing illegal import and export of goods.

Excise Duty :

Duty charged by the government on the production of certain items is called Excise Duty. The liability for the payment of such duty is on the manufacturer of the goods, which is then recovered from the final consumer.

Stamp Duty :

Duty to be paid on the transfer of immovable property within the state is called stamp duty. The duty is charged by the government in whose jurisdiction the property is located.

Also Read : Difference Between Tax and Duty

Taxes Levied by Various Authorities in India

Advantages and disadvantages of direct tax.

• Equity : Direct Taxes are based on the Principle of Ability to Pay and hence it promotes equity of sacrifice on the basis of the volume of income earned by a person during a financial year. Therefore, the rate of tax increases with an increase in the level of income.
• Certainty : As the tax, the slab is determined every year during the budget. It brings awareness to the assessee regarding the quantity of tax to be paid, rate of tax, time of payment, mode of payment, the penalty for non-payment, and so forth.
• Reduces income inequality : As the tax is progressive in nature, so the tax is collected more from the rich and less from the poor people, which tends to reduce income inequality.
• Controls Inflation : Direct taxes act as a tool to curb inflation, by absorbing excess money in circulation, increasing the tax rate, imposing new taxes, etc.
• Relatively Elastic : Direct taxes increase with the increase in income and wealth, which makes it relatively elastic.

Disadvantages

• Tax evasion : Direct tax is a lump sum payment, made to the government by the assessee, so the taxpayer attempts to evade taxes, using various unlawful means.
• Uneconomical : A huge amount is spent on the collection of direct taxes, as it requires a large workforce for its collection and administration.
• Arbitrary : Due to the absence of any scientific principle or logic, in the determination of the degree of progression in the taxes, these taxes are arbitrary in nature.
• Feels like a burden : As a huge amount has to be paid by the assessees in connection to tax, so they treat it as a burden. Also, the documentation process itself is very long and consumes time.

Also Read : Difference Between Tax Avoidance and Tax Evasion

Advantages and Disadvantages of Indirect Tax

• Major source of revenue : As indirect taxes are imposed on the price of goods and services, which include both necessities and luxuries, consumed by a large group of people around the country. So, they contribute to the generation of revenue.
• No Possibility of Tax Evasion : As the tax is added to the price of the goods and services, tax evasion is not possible.
• Convenience : As the taxes are hidden in the price of the commodity and usually of small amount, it becomes easy for the people to pay taxes, as the burden is not felt.
• Economical : Due to the easy and simplified procedure of the collection of these taxes, the cost of collection and administration cost is quite low.
• Wide coverage : Almost all the goods and services are covered under the indirect tax regime. Further, all the individuals around the country, equally contribute to the payment of these taxes. Hence, both haves and have nots contribute to the development of the country.
• Variable Rates : The rate of tax is high for harmful products as compared to the other goods which are necessary for life.
• Regressive : As there is no distinction between rich and poor, the burden of the tax falls on each category equally, making it a regressive tax, which avoids the principle of ability to pay.
• Increases the price of goods and services : As the amount of tax is included in the price of goods and services, it makes them expensive.
• Lack of awareness in consumers : As the price of the commodity includes the amount of tax, many consumers are unaware of the fact that they are paying tax. Hence, it is easier to extract from the general public.

Also Read : Difference Between Tax Credit and Tax Deduction

The imposition of taxes is important for the collective welfare of the society and a means for economic development. A good taxation system possesses the following characteristics – equity, certainty, convenience, redistribution, flexibility, encourage investments, etc.

You Might Also Like:

DEBYENDU PANJA says

December 13, 2015 at 8:40 pm

It is very useful to us.. and please provide me difference between agricultural income and non agricultural income.

Surbhi S says

December 14, 2015 at 4:13 am

Thanks for your appreciation and we will consider your suggestion.

rajesh says

May 29, 2016 at 12:03 am

good comparision but can you proved how direct is progressinve and reduce inflation and similarly for indirect taxes being regressinve and promotes inflation

May 30, 2016 at 9:59 am

The progressive tax is a tax wherein the tax rate increases as the income of the taxpayer increases while the regressive tax is a system of taxation where the rate of tax decreases with the increase of taxable amount. In this way, direct tax cub inflation but indirect tax promotes the same.

kuldeep says

May 17, 2017 at 5:17 pm

Great Article! i visit the page and i find this article much valuable and useful. Thank you for sharing.

sandamali amarasingha says

August 12, 2017 at 10:08 pm

a good effort.. thank you guys.added lot of knowledge.

kartik thakur says

November 24, 2018 at 12:44 am

Bandana says

December 2, 2018 at 1:13 pm

Very useful and clear distinction which I needed . Thank you so much

VJK Sarravanan says

January 19, 2019 at 4:16 am

Superb Ma’am

Shubham says

July 15, 2019 at 7:28 pm

Bijayalaxmi says

August 22, 2019 at 8:17 am

It’s very useful and easy to understand… Thank you so much!!

Quickbooks error code 3371 says

March 22, 2021 at 2:11 pm

You really explained this article very well. I really appreciate your writing skills. Keep up the good work.

Francis says

March 21, 2022 at 1:15 am

Since taxation is paid for the government, does it matter if the tax is direct or indirect

Sneha Rout says

July 8, 2023 at 11:45 pm

It is very clearly defined. Helps a lot to gain information and to clear doubts. Thank You for spreading knowledge to the world.

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The first amendment, interpretation & debate, direct and indirect taxes, matters of debate, common interpretation, still very narrow after all these years—and rightly so, direct and indirect dichotomy: relevant today.

by Neil S. Siegel

David W. Ichel Professor of Law and Professor of Political Science at Duke Law School; Director of Duke's D.C. Summer Institute on Law and Policy

by Steven J. Willis

Professor of Law at the University of Florida Levin College of Law

Despite this essay’s title, the Constitution permits three classes of taxation:

1. Direct taxes, which must be apportioned among the states in proportion to their populations; 2. “Indirect taxes,” specifically duties, imposts, and excises, which must be uniform throughout the country; and 3. Income taxes on humans (as opposed to businesses or other entities), which may apply to income derived from a source.

A Brief History of U.S. Tax Law

Much discussion preceding the Constitution, divided taxes into the direct and indirect categories; however, the Constitution never adopted that precise distinction.  See, e.g. , The Federalist No. 36 (Alexander Hamilton). Nevertheless, Supreme Court decisions such as the License Tax Cases (1867) have routinely used the direct/indirect dichotomy. As early as 1796, in Hylton v. United States , the Supreme Court wrestled with the direct/indirect dichotomy. As the Court explained in that case, direct taxes must be apportioned while indirect taxes—duties, imposts, and excises—must be uniform; and any other tax (if possible) must be uniform. The Court held a tax on “carriages” to be indirect because it applied to the use of the carriage rather than to the property itself, an arguably nuanced distinction.

In 1895, the Supreme Court held a general income tax unconstitutional as an unapportioned direct tax, distinguishing it from a tax on business or employment income, which the Court described as a permissible excise (an indirect tax). Pollock v. Farmers’ Loan & Trust Co . (1895). In contrast, the Court held, in 1911, that a tax on corporate income was constitutional as a uniform excise—a type of indirect tax. Flint v. Stone Tracy Co . (1911) . The Court reasoned that the original income tax applied directly to humans, while the corporate income tax applied through the corporate entity: humans might suffer the tax through higher prices or lower profits, but they would do so indirectly. In 1913, the Sixteenth Amendment authorized an unapportioned tax on income “derived from a source.” The country adopted the Amendment to reverse the 1895 Pollock decision. Many later decisions have wrestled with the “derived” requirement. The best description requires income to constitute “an accession to wealth, clearly realized, over which the taxpayer has complete dominion.” Commissioner v. Glenshaw Glass (1955).

Although some writers describe the direct/indirect and apportionment/uniformity requirements as antiquated, the dichotomies have at least some modern significance. To grasp that significance, one needs to understand the underlying terms.

Direct Tax/Apportionment

A direct tax applies to land or directly to humans “without regard to property, profession, or any other circumstance.” Hylton v. United States (1796); see also NFIB v. Sebelius (2012). Such a tax must be apportioned. At the time of the Constitutional Convention, states with large amounts of land, as well as those with large populations, feared heavier taxes on their land and populations, including slaves, as compared to smaller and less populous states. The apportionment requirement, which also governs representation in the House of Representatives, became the compromise. See Article I, Section 2.

To be apportioned, a tax must be the same amount per person in every state, a very difficult burden to satisfy. For example, a dollar-per-acre tax would fail unless every state had the same acreage per capita. As a result, federal land taxes do not exist. States, unhampered by apportionment, routinely impose real property taxes. In contrast, a dollar-per-human tax (also known as a capitation) would be constitutional, as it would be the same amount per capita in every state. The United States, however, has never imposed such a tax, arguably the only form that a direct tax could constitutionally take.  In 2012, the Supreme Court considered whether the “shared responsibility payment” for lacking health insurance in the Affordable Care Act was a direct tax, and held that it was not: while applying directly to humans, it varies depending on whether they have health insurance, an “other circumstance.” NFIB v. Sebelius . Quoting Hylton , the Court held the required payment to be non-direct, and citing Pollock , concluded that the payment is not an income tax. 

Indirect Tax/Uniformity

Duties, imposts, and excises must be uniform. See Article I, Section 8, Clause 1.  As “indirect” taxes, they do not apply directly to humans. For example, a duty applies to the act of importing property. Although the ultimate purchaser suffers the tax, the incidence (or burden of the tax) is thought to fall primarily on the importer, and therefore it is considered to be indirect. Excises commonly apply to tires, telephone charges, gambling, employment, and corporate income. In each case, humans may ultimately suffer the tax through higher prices or lower wages, but the incidence is viewed as indirect through the seller, employer, or entity.

Unlike apportionment, uniformity does not require each person to pay the same amount; instead, it requires the same rate structure to exist nationally. For example, Congress may tax truck tires differently than bicycle tires; but however it taxes truck tires, the specific truck tire rates must be the same in every state. As such, it is a geographic requirement. Steward Machine Co. v. Davis (1937); Flint v. Stone Tracy Co . (1911); Knowlton v. Moore (1900). The Supreme Court has never struck down an indirect tax as failing uniformity, although it has considered the issue several times. Uniformity analysis is not easily reducible to black-letter rules; nevertheless, some such rules emerge:

1. Taxes may vary by an object’s value or the taxpayer’s income so long as the rates are uniform. They may even apply to objects or transactions found only in some states, such as snow tires in the north or beach umbrellas in coastal states. Edye v. Robertson (Head Money Cases) (1884). 2. Tax rates may vary if based on physical, such as coastlines and frigid conditions; however, such variations necessitate a particularly close examination. For instance, in United States v. Ptasynski (1983), the Court distinguished arctic oil from oil produced elsewhere. It upheld a tax on income derived from oil pumped above the Arctic Circle. Rates may also vary because of isolated problems or “diverse conditions.”  Florida v. Mellon   (1927). How isolated or diverse the problem or condition must be is unclear.

Income Tax/Derived

Income taxes may be imposed only on “derived” income. This “realization event” requirement generally refers to a transaction other than the mere passage of time.  Thus the Sixteenth Amendment permits taxation of gains from sales or exchanges of property, but not those resulting merely from increased values. It also permits taxes on rents and interest. Although direct, such taxes need not be apportioned because the Amendment eliminated the apportionment requirement for income taxes. 

The fourth clause of Article I, Section 9, is known as the “Direct Tax Clause.”  It provides that “[n]o Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.” This Clause requires that the financial burden of any “direct” tax imposed by Congress fall equally on each state in the Union in terms of its population. For example, if two states have the same population, then the citizens of each state collectively must pay the same amount of direct tax to the U.S. Treasury. 

While it is clear how apportionment works, it was less clear at the time of the Founding which kinds of taxes qualified as “direct,” and so were subject to apportionment. According to Madison’s notes of the proceedings of the Constitutional Convention in 1787, Massachusetts delegate Rufus King at one point “asked what was the precise meaning of direct taxation?  No one answd.”  The text of Section 9 contemplates that “capitation” taxes, otherwise known as “head” or “poll” taxes, qualify as direct taxes.  Capitations are taxes on people in simple virtue of the fact that they exist. The constitutional text also seems to imply that at least one other kind of tax qualifies as direct.

The original purpose of requiring apportionment for direct federal taxes appears to have been to benefit Southern states. Specifically, the apportionment requirement was primarily designed to render impracticable federal head taxes on slaves and federal taxes on land, both major sources of wealth in eighteenth century America. Without the requirement of apportionment by state population, the burden of both kinds of federal taxes would have fallen most heavily on the South, because it possessed disproportionately more wealth in land and slaves than did the North. By contrast, apportioning any such tax by state population would have fallen most heavily on the North, because it was home to the most populous states. 

This original purpose explains why the third clause of Article I, Section 2 , provides that both “Representatives and direct Taxes shall be apportioned among the several States.” The more people who live in a state, the more representation in Congress that state receives, and the more its citizens collectively pay in direct taxes. The practical consequence of requiring apportionment for head taxes on slaves and taxes on land was that the federal government did not tax slaves or land. The Thirteenth Amendment ended the possibility of head taxes on slaves, and to this day Americans do not pay property tax to the federal government. 

From the beginning, the Supreme Court has understood only very few taxes to be subject to the apportionment requirement. In its first case considering the issue, Hylton v. United States (1796), the justices who wrote opinions included only capitation and land taxes within the category of direct taxes. Throughout the nineteenth and twentieth centuries, the Court upheld federal taxes that had not been apportioned on insurance premiums, state bank notes, inheritances, trades, personal income, and corporate income. The Court reasoned that all of those taxes were excise taxes, not direct taxes.  See, e.g. , Bruce Ackerman, Taxation and the Constitution , 99 Columbia Law Review 1 (1999). 

The major exception is the Court’s decision in Pollock v. Farmers’ Loan & Trust Co . (1895), which invalidated the progressive federal income tax statute then in effect. In that case, the Court remarkably and inconsistently held that federal taxation of income that was derived from real or personal property (such as rental or dividend income) was direct and so subject to apportionment, in contrast to income taxes on wages and business profits, which were not. The Pollock Court confused matters by reasoning that certain income taxes could qualify as direct taxes on the underlying property from which the income was derived. 

The Sixteenth Amendment was ratified in 1913 in order to overrule the decision.  It authorizes Congress to tax “incomes, from whatever source derived, without apportionment of the several States,” thus tracking the previous, longstanding rule on direct taxes. The Sixteenth Amendment makes clear that income, not ownership, is being taxed, so there is no requirement of apportionment and thus no constitutional problem.

Today, the Direct Tax Clause operates to render impracticable only federal capitations, federal taxes on the ownership of land, and federal taxes on personal property.  Murphy v. IRS  (D.C. Cir. 2007). For example, the minimum coverage provision in the Patient Protection and Affordable Care Act (ACA) requires most individuals to either obtain health insurance or make a payment to the Internal Revenue Service. In NFIB v. Sebelius (2012), the Supreme Court, after upholding the required payment as a tax for purposes of the Taxing Clause in the first clause of Article I, Section 8, rejected the argument that it was a direct tax and so had to be apportioned. The Court’s holding is plainly correct. The required payment for going without health insurance in the ACA is a tax on those who choose to remain uninsured, not a head tax on those who simply exist, or a tax on land ownership, or a tax on personal property. It is therefore not a direct tax and need not be apportioned.

Excepting Pollock , the Court has been right all these years to define the category of direct taxes very narrowly. As discussed, a narrow definition is most consistent with the constitutional text, the original purpose of the Direct Tax Clause, the Court’s precedent, and the Sixteenth Amendment. 

A narrow definition also makes good sense from a consequentialist perspective. The Constitution confers robust federal power to tax on the theory (grounded in experience) that taxation with representation is a necessity. Requiring apportionment, however, renders federal taxation impracticable. 

Apportionment also requires the federal government to privilege regressivity over progressivity in taxation. Apportionment means that citizens of relatively wealthy states must pay at lower rates than citizens of relatively poor states in order to make the total payment for states of equal population come out the same. Such a tax regime is difficult to defend morally, particularly in an America in which the income distribution is increasingly skewed in favor of a very small number of extraordinarily wealthy Americans. 

Finally, such a tax regime is difficult to defend from a structural, federalism perspective.  States that impose progressive income taxes are at a competitive disadvantage in attracting wealthy residents relative to states that do not.  See, e.g. , Akhil Reed Amar, America’s Constitution: A Biography 408 (2005).  Only progressive taxation at the federal level can overcome the collective action problem and avoid a destructive “race to the bottom.”

The direct/indirect tax dichotomy remains important because it affects the types of tax the federal government can impose. Classification between the two categories, as well as application of the apportionment and uniformity tests can determine the validity of modern statutes.

Very difficult to satisfy, the apportionment requirement can be met only with a capitation—a direct tax on humans simply because they are humans. To satisfy apportionment, the tax would necessarily be the same per person nationwide. Congress has never enacted such a tax and arguably is unlikely to do so in the foreseeable future. That equality requirement is a powerful restriction on the taxing power: remember, the income tax is progressive and applies much more heavily on high-income persons than on others. Because the income tax is not subject to apportionment—largely because of the Sixteenth Amendment —progressivity is possible. In addition, Congress cannot impose a property tax on land. Apportioning such a tax would be impossible because the amount of land per person is not the same in every state. Land taxes —known as ad valorum and “property taxes”—however, are very important to the states, with many states raising a substantial portion of their revenue from them. Restricting such taxes to the states is another very significant restriction on the federal taxing power.

Although Congress cannot impose a property tax directly on personal property —such as cars, furniture, stocks or bonds—as opposed to land— , it has two fairly easy work-arounds for such taxes. NFIB v. Sebelius (2012). Since 1796, the Supreme Court has viewed a tax on the use of personal property as an indirect tax subject to uniformity rather than to apportionment. Hylton v. United States (1796) (Chase, J.). As a result, it could easily style a tax on automobiles as a tax on the use of the item and thus avoid apportionment. Indeed, because the number of cars (or any other personal item) is unlikely ever to be the same per capita in every state, without the Hylton decision, a federal personal property tax would be impossible because it could never satisfy apportionment. Although Congress does not often impose direct taxes on personal property, Congress routinely imposes similar taxes on the purchase of personal property such as tires and gasoline, styling them as excises subject merely to uniformity. Significantly, it could impose a nationwide automobile or telephone usage tax.

Until 1913, a tax on either personal or real property income was effectively forbidden because such taxes were considered direct and not easily apportioned. Pollock v. Farmers’ Loan & Trust Co . (1895). The Sixteenth Amendment resolved this by replacing the income tax apportionment requirement with a new requirement that a tax on income need not be apportioned so long as the tax is imposed on income “derived from a source”—a serious, but different restriction.

In 2012, the Supreme Court narrowly read the direct tax definition in relation to the Affordable Care Act (ACA). The Court held the ACA penalty on persons without minimum health insurance to be a tax; however, the Court also held it not to be “any kind of direct tax.” NFIB v. Sebelius (2012). In so doing, the Court made two critical points. First, by citing Pollock favorably, the Court removed any argument that the “penalty” was supportable as an income tax subject to the “derived” test. That was important because the “tax” is, in part, a function of a person’s income. Without the Sixteenth Amendment as a possible foundation, the tax/penalty must satisfy either apportionment or uniformity. Second, the Court relied on the often-quoted 1796 Hylton language: a direct tax is one imposed “without regard to property, profession, or any other circumstance .” Finding the lack of health insurance an “other circumstance,” the Court found that the mandate to purchase insurance was not a direct tax, and it rejected apportionment as applying to the ACA.

Interestingly, the Court quoted Justice Chase out of context. Chase actually said: “ I am inclined to think, but of this I do not give a judicial opinion, that the direct taxes contemplated by the Constitution are only two, to wit, a capitation or poll tax simply, without regard to property, profession, or any other circumstances, and the tax on land.” Hylton v. United States (1796) (Chase, J.). The NFIB Court thus omitted Chase’s independent clause and quoted only the dependent clause, which he described as not his “judicial opinion”; however, it labeled the quotation as “opinion of Chase, J.” which is best described as misleading. Nevertheless, the NFIB decision appears settled: the ACA tax is neither a direct tax nor an income tax.

But discussion of a tax which is neither direct nor an income tax necessarily raises the issue of uniformity. Uniformity is a much easier-to-satisfy requirement than apportionment.  It is all about geography: the tax must apply the same in every state.

Few Supreme Court decisions have applied uniformity and none has invalidated a tax because of it. Essentially, the geographic element of uniformity applies in a laxer manner if the natural geographic variations among states justify a lack of uniformity or if a particular state’s behavior causes it. For example, the Court upheld a charge on immigration through sea ports though it had no impact on land-locked states, finding that there was substantial uniformity. Edye v. Robertson (Head Money Cases) (1884). Similarly, in 1983 the Court upheld a difference between taxes on income from oil pumped above the arctic circle and taxes on income from oil pumped elsewhere, noting that there were important natural differences in the oil and the extraction process. United States v. Ptasynski (1983). In 1927, the Court upheld the estate tax although it ultimately applied differently to Florida. Florida v. Mellon (1927). The difference, however, resulted from a particular Florida statute which created the lack of uniformity. Thus a state cannot self-impose non-uniformity and then complain about it.

Significantly, the NFIB decision did not discuss “uniformity.” The Court likely avoided addressing this issue because it was premature: because the Act was not yet operable, no facts indicating uniformity or the lack thereof were available. Since 2014, however, the tax on persons without health insurance has applied differently in the various states.  It varies as a function of the cost of health insurance in each state, as well as the federal “poverty level,” which itself varies between Alaska, Hawaii, and other states. As a result, the ACA tax can vary from one person to another even though the two persons may reside less than a mile apart. The only important distinction may be the man-made political boundary between them: the state line.  Whether the Supreme Court will hear a case challenging the ACA for lack of uniformity is unclear. If it does, that may be the first instance in which the constitutional restriction has a real impact.

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Theme 4: What Is Taxed and Why Lesson 4: Direct and Indirect Taxes

Educational Standards

State and National Standards

One to four hours

Curriculum Area(s)

• Civics/Government
• History/Social Studies

To help students understand that a tax levied on one person or group may ultimately be paid by others

Students will be able to

• explain that all taxes are ultimately paid by the individual.
• define direct tax and indirect tax and differentiate between them.

Taxes can be either direct or indirect. A direct tax is one that the taxpayer pays directly to the government. These taxes cannot be shifted to any other person or group. An indirect tax is one that can be passed on-or shifted-to another person or group by the person or business that owes it.

Businesses may recover the cost of the taxes they pay by charging higher prices to customers, paying lower wages and salaries, paying lower dividends to shareholders, or accepting lower profits.

Ultimately, individuals pay almost all taxes. Businesses and corporations use a tax shift to pass taxes on to their customers, clients, patients, employees, and stockholders.

A tax that cannot be shifted to others, such as the federal income tax.

indirect tax

A tax that can be shifted to others, such as business property taxes.

The process that occurs when a tax that has been levied on one person or group is in fact paid by others.

Opening the Lesson

Ask students what taxes people pay directly to the government. Make sure that students understand that income and property taxes are paid directly to the government. Other taxes, such as sales tax, are paid indirectly. For example, a store tells you how much sales tax is owed on the item. You pay the store the sales tax, and the store pays the tax to the government. Some indirect taxes are harder to see.

Developing the Lesson

Have students examine factors that determine the price of a product. Use milk as an example. In addition to supply and demand, the milk price reflects the costs of the storeowner, the dairy, and the farmer. All three must pay for the lease or purchase of a facility, equipment, maintenance, salaries of employees, and taxes.

Taxes include property taxes, payroll taxes, sales or excise taxes on equipment, and corporate or business income taxes. Ask students:

• How do business owners get the money to pay their taxes? Explain that business owners must charge enough for their products to cover their expenses, which include taxes. The customer who buys milk at the store pays a portion of the taxes of each business that has handled it.

Online Activity

Direct students to Student Lesson: Direct and Indirect Taxes .

Have students complete one or more of the following activities:

Activity 1: Classifying Direct and Indirect Taxes -Classify taxes as Direct or Indirect.

Activity 2: Business Beginnings -Discover how business location affects profits and taxes.

Activity 3: Chuck's Chocolate Factory -How are profits affected when you shift rising property taxes to your customers?

Activity 4: Tax Your Memory -Test your tax IQ when you play this memory concentration game.

Print Activity

Print Worksheet: Tax and Gourmet Chocolates and distribute it to students.

Worksheet Solutions: Tax and Gourmet Chocolates

Classroom Activity

Study Info Sheet: Flow of Direct and Indirect Taxes to understand the differences between direct and indirect taxes. Ask a student to summarize how businesses can shift taxes. Organize students into groups. Have each group write a plan for opening a new business and describe the nature of the business, telling what it makes or does. Have each group brainstorm a list of expenses, including taxes and user fees, they will incur in day-to-day business operations. Each group should explain how it would pay for its business expenses.

Concluding the Lesson

Ask students to explain why taxpayers sometimes consider sales taxes and other indirect taxes more acceptable than income and property taxes. Help students understand that although some taxes, such as sales taxes, may be hidden in the cost of goods, individuals ultimately pay them.

Online Assessment

Direct students to complete Assessment: Direct and Indirect Taxes for this lesson.

Assessment Solutions: Direct and Indirect Taxes

Print Assessment

Print Assessment: Direct and Indirect Taxes and have students complete it on paper.

tell us what you think!

Direct taxation

Direct taxation is a type of tax which is paid for by an individual directly to the government. It includes poll tax, land tax or income tax.

Direct taxation contrasts with an indirect tax, which is imposed on a transaction and paid to the government by the firm after the good has been bought. Indirect taxes include VAT and sales tax. With an indirect tax, the firm can choose how much of the tax to pass on to the consumer in the form of higher prices. When a consumer buys a good, he is not responsible for paying VAT. But, with a direct taxation, he is responsible for paying it all to the government.

Direct taxes in the UK

• Corporation Tax
• Capital Gains Tax
• National Insurance Contributions
• Statutory Payments
• Inheritance Tax
• Petroleum Revenue Tax
• Student Loans
• Stamp Taxes
• Indirect taxes
• Customs Duty
• Excise Duties
• Insurance Premium Tax
• Environmental taxes, including Air Passenger Duty
• Climate Change Levy
• Aggregates Levy
• Landfill Tax

Direct taxes and unavoidable taxes

In earlier times, direct taxes had a different emphasis. A direct tax was considered to be one that was unavoidable to pay. e.g. a simple poll tax was payable by everyone. There was no choice but to pay.

By contrast, an excise duty had an element of choice – if you don’t want to pay the excise duty, you don’t have to buy the alcohol. For political purposes, this distinction was important. The idea of direct taxes was equated with political tyranny. The Pennsylvania Minority, a group of delegates to the 1787 U.S. Constitutional Convention complained about the principle of direct taxation in the US constitution.

“The power of direct taxation applies to every individual … it cannot be evaded like the objects of imposts or excise, and will be paid, because all that a man hath will he give for his head. This tax is so congenial to the nature of despotism, that it has ever been a favorite under such governments. …”

In a way income tax is avoidable. You could choose not to earn a salary and live off the land (subsistence farming). In that way, you don’t have to be liable to pay income tax. However in a modern economy, for practical purposes, most people wouldn’t see it like this. Income tax is a non-transferable tax, payable by the person who gains the salary.

US vs UK distinction

In the US direct taxes are considered taxes on property or a poll tax ‘tax per head’ In the US, income taxes on wages are considered indirect taxes.

In the UK, income taxes are considered direct taxes

• Tax revenue sources
• Inelastic demand and taxes
• Ad valorem taxes – % of final price

3 thoughts on “Direct taxation”

Thank you so much for this great content. Can you please cover effects of the direct and indirect tax. (OCR economics) Nobody in my class understands and it would be a great pleasure if you could do this.

Effect of income tax cuts (direct) https://www.economicshelp.org/blog/13566/economics/the-effect-of-tax-cuts/

Effect of specific tax – https://www.economicshelp.org/blog/794/economics/effect-of-tax-depending-on-elasticity/

put advantages and disadvantage

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Advantages and Disadvantages of Indirect Taxes

Read this article to learn about Advantages and Disadvantages of Indirect Taxes!

Advantages of Indirect Taxes:

Indirect taxes have advantages of their own.

Briefly speaking, they are as under:

(i) The Poor Can Contribute:

ADVERTISEMENTS:

They are the only means of reaching the poor. It is a sound principle that every, individual should pay something, however little, to the State. The poor are always exempted from paying direct taxes. They can be reached only through indirect taxation.

(ii) Convenient:

They are convenient to both the tax-prayer and the State. I he tax-payers do not feel the burden much partly because an indirect tax is paid in small amounts and partly because it is paid only when making purchases. But the convenience is even greater due to the fact that the tax is “price-coated”.

It is wrapped in price. It is like a sugar-coated quinine pill. Thus, a tobacco tax is not felt when it is included in the price of every cigarette bought. It is convenient to the State as well which can collect the tax at the ports or at the factory.

(iii) Broad-based:

Indirect taxes can be spread over a wide range. Very heavy direct taxation at just one point may produce harmful effects on social and economic life. As indirect taxes can be spread widely, they are more beneficial and suitable.

(iv) Easy Collection:

Collection takes place automatically when goods are bought and sold. A dealer collects the tax when he charges a price. He is an honorary tax collector.

(v) Non-evadable:

They cannot be evaded, as they are a part of the price. They can be evaded only when the taxed article is not consumed, and ‘his may not always be possible’

(v) Elastic:

They are very elastic in yield, imposed on necessaries of life which have an inelastic demand. Indirect taxes on necessaries yield a large revenue, because people must buy these things.

(vi) Equitable:

When imposed on luxury or goods consumed by the rich, they are equitable. In such cases, only the .Veil-to-do will pay the tax.

(vii) Check Harmful Consumption: .

By being imposed on harmful products, they can check consumption of harmful commodities. That is why tobacco, wine and other intoxicants are taxed.

Disadvantages :

Indirect taxes have some disadvantages too, which are as follows:

(i) Regressive:

Indirect taxes are not equitable. For instance, salt tax in India fell more heavily on the poor than on the rich, as it had to be paid at the same rate by all. Whether a rich man buys a commodity or a poor man, the price in the market is the same for all. The tax is wrapped in the price. Hence, rich and poor pay the same amount, which is obviously unfair. They are thus; regressive.

(ii) Uncertain:

Unless indirect taxes are imposed on necessaries, we cannot be sure of the revenue yield. In the case of goods, with an elastic demand, the tax might not bring in much revenue. The tax will raise the price and contract the demand. When the thing is not purchased, the question of the tax payment does not arise.

(iii) Raising Prices Unduly:

They cause the price of an article to rise b; more than the tax. A fraction of the money unit cannot be calculated, so ever middleman tends to charge more than the tax. This process is cumulative.

(iv) Uneconomical:

The cost of collection is quite heavy. Every source o production has to be guarded. Large administrative staff is required to administer such taxes. This turns out to be a costly affair.

(v) No Civic Consciousness:

These taxes do not develop civic consciousness, because many times the tax-payer does not even know that he is paying tax. The tax is concealed in the price.

(vi) Harmful to Industries:

They discourage industries if raw materials are taxed. This will raise the cost of production and impair their competitive capacity.

Direct Vs. Indirect Taxes :

In answer to the question whether direct or indirect taxes are better, much can be said on both sides. But it is safe to conclude that no country can do with one type only. Both types have to be mixed in a good system of taxation.

The rich can be taxed best directly, but pockets of the poor have also to be tapped through indirect taxes. Nowadays, when the state functions are multiplying, substantial amounts are required for the discharge of its multifarious activities. Neither the direct nor the indirect taxes alone can raise adequate revenue. Both are necessary.

Their relative importance depends on a number of factors, such as distribution of income, nature of the economic system, the stage of economic development, etc. Thus, the discussion of the relative merits and demerits of direct and indirect taxes is only academic. It has no practical importance.

Related Articles:

• Advantages and Disadvantages of Direct Taxes – Discussed!
• Merits and Demerits of Indirect Taxes
• Difference between Direct and Indirect Taxes of India
• Excess Burden of Indirect Taxes (With Diagram) | Economics

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Direct And Indirect Taxes Essay Example

Type of paper: Essay

Topic: Taxes , Income , Inequality , Social Issues , Segment , Bottom , Population , Increase

Words: 1400

Published: 02/20/2023

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INEQUAILITY OF INCOME

The degree of inequality of income in an advanced economy can be measure by measuring the amount of income that is earned through different segments of the population. For example, “if we break down all workers into five different segments in regards to how much money they make: the top 20 percent, the second 20 percent, the third 20 percent, the fourth 20 percent, and the bottom 20 percent,” then an individual is able to create a chart that details how much income each segment of the population earns out of the total amount of income for that area ( Carter, 2016). The first part of measuring the degree of inequality, or equality, would be to fine the total income for the area. For example, the average income for the five different segments of the population would be, $10,000, $25,000, $50,000, $75,000 and $100,000. The next step would be to figure out the percentage of the total income each segment makes. If the segments are all equal sizes, then there is no need to worry about weighting the average incomes. For this example, all of the segments are the same size. Thus, all that needs to be done are calculations in order to find the percentage of total income each segment makes (Carter, 2016). For the total income, the average amounts of income for each segment should be added together ($10,000 + $25,000 + $50,000 + $75,000 + $100,000 = $260,000). Next, an economist would find the percentage of the total income that each segment earns. This is done by dividing the total income of the segment by the total income for the population. For the first segment, $10,000/$260,000 = .038. For the second segment, $25,000/$260,000 = .096. For the third segment, $50,000/$260,000 = .192. For the fourth segment, $75,000/$260,000 = .288, and for the last segment, $100,000/$260,000 = .384. What these numbers represent is that the bottom fifth of the population represents less than four percent of the total income in that area, while the top fifth represents almost forty percent (Carter, 2016). Economists also look at cumulative figures when it comes to income distribution. In order to use cumulative figures, the percentages are added together are each level in order to see the amount of income earned by all of the people who exist throughout the population. For example, the bottom segment represents 3.8 percent of the income. The bottom segment and the second segment (3.8 + 9.6 = 13.4) represents 13.4 percent of the total income. The first, second, third, and fourth segments (3.8 + 9.6 + 19.2 + 28.8 = 61.4) represent 61.4 percent of the total income. Lastly, the first, second, third, fourth, and fifth segments (3.8 + 9.6 + 19.2 + 28.8 + 38.4 = 99.9) represent 99.9 percent of the total income (Carter, 2016).

Tax policies can play a role when it comes to the inequality of post-tax income distribution. “In addition, tax policy is crucial for raising revenues to finance public expenditures on transfers, health and education that tend to favor low-income households, as well as on growth enabling infrastructure that can also increase social equity” (Carter, 2016). It is believed that income inequality was affected originally by the tax system. By analyzing current tax systems, economics were able to discover that under certain conditions, tax productivity may actually improve inequality when it comes to income. Direct and indirect taxes can be used to help reduce the degree of inequality. Indirect taxes are when every person (whether poor or rich) pays the same amount when it comes to consumption expenditures. “But since the poor pay a higher proportion of their income as tax, indirect tax tends to increase the disparity in societal wellbeing” (Ilaboya & Ohanba, 2013, p. 1). Direct takes, on the other hand, tend to be more equitable. This is due to the fact that direct taxes fluctuate with income. The more income a person makes, the more direct taxes they are assessed. “Direct taxes enhances the redistribution function of taxation as they help reduce income inequality” (p. 1). For example, a study was conducted in Europe to attempt to see the impact that direct and indirect taxes have different households with different incomes. One average, the households in the study paid $7,400 a year in direct taxes. This number was equivalent to 19 percent of their gross income. Richer households, on the other hand, paid both higher proportions of their income in direct taxes and higher amounts of direct taxes. Thus, direct taxes reduced the level of inequality when it comes to income. The top fifth of households paid $20,300 per year on average in direct taxes. This represented 24 percent of the individual’s total gross income. For the lowest fifth, on the other hand, the average direct tax bill was $1,300 a year. This consisted of ten person of their total gross income. The total differences of income for this same were $63,600 per year and $11,400 per year for the top and bottom fifth of the population respectively (Creamer, 1999). With indirect taxes, on the other hand, each household is responsible for paying taxes on their expenditures instead of their income. The top fifth of households paid two and a half times in indirect taxes as the lowest fifth ($9,100 and $3,500 a year respectively). These means the higher income households spent more on expenditures on goods and services than the poor individuals. “However, although richer households pay more in indirect taxes than poorer ones, they pay less as a proportion of their income” (Ilaboya & Ohanba, 2013, p. 4). This means that indirect taxes are actually acting to increase the inequality when it comes to income. For example, the study found that the richest fifth of households only paid 14 percent of their income in indirect taxes. The bottom fifth, on the other hand, paid approximately 31 percent of their income in indirect taxes. The poorer individuals end up paying a higher percent of their income in indirect taxes than in direct taxes. Direct and indirect taxes can have an impact when it comes to income inequality. With indirect taxes, income inequality is only increased. With direct taxes, on the other hand, income inequality is decreased. Applying the concept of direct taxes to developed countries is a way to limit the amount of income inequality that exist throughout a particular area. Indirect taxes not only increase the amount of inequality in income, but they also are unfair on the poorer individuals throughout society. The top fifth and bottom fifth of the area in the European study earned an income of $63,600 and $11,400 per year respectively. With indirect taxes, these individuals only paid $9,100 and $3,500 in indirect taxes per year. In other words, the top fifth spent 14.3 percent ($9,100/$63,600 = .143) of their income on indirect taxes, whereas the bottom fifth spent 30.7 percent ($3,500/$11,400 = .307) of their income on indirect taxes. Thus, indirect taxes do not help the issue with inequality of income throughout a particular area. Indirect taxes actually do the opposite; the increase the amount of income inequality that exists throughout a particular are. Therefore, direct taxes should be used in order to limit the amount of income inequality that exists throughout a given area.

Carter, A. (n.d.) How tax can reduce inequality. Retrieved on 8 March 2016, from http://www.oecdobserver.org/news/fullstory.php/aid/3782/How_tax_can_reduce_inequal ty.html Creamer, H. (1999). Direct versus indirect taxation: the design of the tax structure revisited. Retrieved on 8 March 2016, from http://idei.fr/sites/default/files/medias/doc/by/cremer_h/direct_indirect.pdf Garfinkel, I. (2006). A re-examination of welfare states and inequality in rich nations: how in-kid transfers and indirect taxes change the story. Journal of Policy Analysis and Management, 24(4), 897-919. Ilaboya, O. & Ohanba, N. (2013). Direct verse indirect taxation and income inequality. European Journal of Accounting Audit and Finance Research, 1(1), 1-15.

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• Taxation Direct and Indirect taxes

Taxation Direct and Indirect taxes - Essay Example

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• Taxation India

Taxation in India

The taxation system in India is such that the taxes are levied by the Central Government and the State Governments. Some minor taxes are also levied by the local authorities such as the Municipality and the Local Governments.

To run the government and manage the affairs of a state, money is required. So the government imposes taxes in many forms on the incomes of individuals and companies.

Classification of Taxes

Broadly taxes are divided into two categories:

Direct Taxes

Indirect taxes.

This is an important topic for IAS Exam . In this article, relevant details related to taxation in India have been provided.

Taxation in India (UPSC Notes):- Download PDF Here

A direct tax can be defined as a tax that is paid directly by an individual or organization to the imposing entity (generally government). A direct tax cannot be shifted to another individual or entity. The individual or organization upon which the tax is levied is responsible for the fulfilment of the tax payment.

The Central Board of Direct Taxes deals with matters related to levying and collecting Direct Taxes and formulation of various policies related to direct taxes.

A taxpayer pays a direct tax to a government for different purposes, including real property tax, personal property tax, income tax or taxes on assets, FBT, Gift Tax, Capital Gains Tax, etc.

The term indirect tax has more than one meaning. In the colloquial sense, an indirect tax such as sales tax, a specific tax, a value-added tax (VAT), or goods and services tax (GST) is a tax collected by an intermediary (such as a retail store) from the person who bears the ultimate economic burden of the tax (such as the consumer).

The intermediary later files a tax return and forwards the tax proceeds to the government with the return. In this sense, the term indirect tax is contrasted with a direct tax which is collected directly by the government from the persons (legal or natural) on which it is imposed.

To know about goods and service tax in detail, check the linked article.

Some of the important Direct taxes:-

Fringe Benefit Tax

To reduce the profit on booked entry, many companies started providing various benefits to their employees and maintaining them under their input cost. Thus reducing the profit which in turn leads to less taxation by the government.

Therefore government-imposed Fringe Benefits Tax (FBT) which is fundamentally a tax that an employer has to pay instead of the benefits that are given to his/her employees. It was an attempt to comprehensively levy a tax on those benefits, which evaded the tax.

The list of benefits encompassed a wide range of privileges, services, facilities, or amenities which were directly or indirectly given by an employer to current or former employees, be it something simple like telephone reimbursements, free or concessional tickets, or even contributions by the employer to a superannuation fund.

FBT was introduced as a part of the Finance Bill of 2005 and was set at 30% of the cost of the benefits given by the company. This tax needed to be paid by the employer in addition to the income tax, irrespective of whether the company had an income-tax liability or not.

The fringe benefits tax was abolished in the 2009 Union budget of India.

Minimum Alternate Tax

The concept of Minimum Alternate Tax (MAT) was introduced in the direct tax system to make sure that companies having large profits and declaring substantial dividends to shareholders but who were not contributing to the Government by way of corporate tax, by taking advantage of the various incentives and exemptions provided in the Income-tax Act, pay a fixed percentage of book profit as minimum alternate tax.

As per the Income Tax Act, if a company’s taxable income is less than a certain percentage of the booked profits, then by default, that much of the book profits will be considered as taxable income and tax has to be paid on that.

It is called MAT and is a direct tax. It was introduced to deter some companies who managed their account in such a way that they end up paying zero or no tax to the government.

The current rate of MAT is 18.5%.

Alternate Minimum Tax

Under the existing provisions of the Income-tax Act, Minimum Alternate Tax (MAT) and Alternate Minimum Tax (AMT) are levied on companies and limited liability partnerships (LLPs) respectively.

That means what is MAT to the companies, AMT is to the LLPs. However, no such tax is levied on the other form of business organizations such as partnership firms, sole proprietorships, an association of persons, etc.

To widen the tax base vis-à-vis profit linked deductions, it is proposed to amend provisions regarding AMT contained in the Income-tax Act to provide that a person other than a company, who has claimed deduction under any section (other than section 80P), shall be liable to pay AMT.

Under the proposed amendments, where the regular income-tax payable for a previous year by a person (other than a company) is less than the alternate minimum tax payable for such previous year, the adjusted total income shall be deemed to be the total income of such person and he shall be liable to pay income-tax on such total income at the rate of eighteen and one-half percent.

Aspirants can also refer to the following links for UPSC exam preparation:

Indirect Taxes in India

Indirect taxes in India can be broadly classified into:

• Production of goods: Excise or CenVAT
• Distribution of goods: Sales Tax
• Production and Distribution of services (because they can’t be separated):
• Service Tax

In India, generally, taxes on production or manufacturing (Excise) is levied by the centre, and taxes on sales (Sales Tax) is levied by the states.

Excise duties

Excise duty (Central VAT) is a tax on the manufacture of goods within the country. Excise duties are levied under the Central Excise and Salt Act, 1944, the Excise Tariff Act, 1985, and the Modified Value Added Tax (MODVAT) scheme or CENVAT.

The rates of excise duty levied vary depending inter alia on the nature of the item manufactured, the nature of the manufacturing concern, and the place of ultimate sale.

The duty rates are either ad valorem (i.e. a fixed percentage of the cost of production), specified (a fixed rate depending on the nature of the manufactured item, for example, length of product or count of product), or a combination of both.

The MODVAT scheme, introduced in 1986, on the recommendation of the L K Jha Committee, applies to certain specific items.

The objective of this scheme is to limit the cascading effect of duty incidence on several goods subject to excise which are further used as inputs for other excisable goods.

Under the scheme, MODVAT credit can be claimed on the purchase of raw materials on which excise has been paid.

This MODVAT credit can be used to set off excise duty payable on subsequent manufacture of goods.

Sales tax is levied on the sale of a commodity that is produced or imported and sold for the first time.

If the product is sold subsequently without being processed further, it is exempt from sales tax. Sales tax is levied by either the Central or the State Government, Central Sales tax, or 4% is generally levied on all inter-State sales.

State sales taxes that apply to sales made within a State have rates that range from 4 to 15%. However, exports and services are exempt from sales tax.

Service tax

Service tax is a part of Central Excise in India. It is a tax levied on services provided in India, except the State of Jammu and Kashmir.

The responsibility of collecting the tax lies with the Central Board of Excise and Customs (CBEC).

Frequently Asked Questions on Taxation in India

Q 1. what are the major state taxes in india, q 2. what is the goods and services tax, q 3. which are the major central taxes in india.

Ans. There are four major Central Taxes in India:

• Central Goods & Services Tax (CGST)
• Customs Duty
• Integrated Goods & Services Tax (IGST)

Q 4. What is the difference between Direct and Indirect Tax?

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Why calculating your company’s carbon footprint matters

EY US Quantitative Economics and Statistics (QUEST) Senior Manager

EY US National Tax Quantitative Economics and Statistics Group (QUEST) Co-Director

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Why calculating your company’s carbon footprint matters (pdf), with the focus on climate issues and potential policy approaches, businesses need to know their carbon footprint and how they may be affected..

• Company environmental, social and governance policy and reporting has become increasingly important.
• Climate change and climate risk have taken center stage, and companies need to understand their carbon footprint to properly disclose risks and opportunities.
• Close examination of both direct and indirect carbon emissions in a company’s supply chain can help them measure and understand their carbon footprint.

C ompany environmental, social and governance (ESG) policy and reporting has become increasingly important. Investors are weighing ESG considerations when making investment decisions, and consumers and employees seek additional engagement and transparency on these issues. Climate change and climate risk have taken center stage in these discussions, and companies need to understand their carbon footprint to allow them to appropriately disclose risks and opportunities.

This article examines the sources of carbon dioxide (CO2) emissions throughout the US economy and highlights issues companies need to think about when determining their carbon footprint. It uses the EY Carbon Modeling Tool to show how a close examination of both direct and indirect carbon emissions embedded in a company’s supply chain can help companies measure and understand their carbon footprint.

Direct vs. indirect carbon emissions

Included in a company’s carbon footprint are both its direct and indirect carbon emissions. Direct carbon emissions are emissions incurred directly by the company via heating/cooling, company-owned vehicles, etc. Indirect carbon emissions are those emissions embedded in a company’s supply chain.

Direct carbon emissions as a share of a company’s total carbon footprint (i.e., the sum of its direct and indirect emissions) can vary significantly across industries.

For example, while the average carbon footprint for a company in electric power generation is 97.8% direct emissions (and 2.2% indirect emissions), the average carbon footprint for a company in wholesale and retail trade is only 1.3% direct emissions (and 98.7% indirect emissions).

Emissions sources — the hot spots

While concentrated more heavily in some industries, carbon emissions occur throughout the US economy. Industry is responsible for 71% of these emissions, while residential petroleum and natural gas emissions, light-duty vehicles and government functions are responsible for the remaining 29%. Electric power generation accounts for nearly half of industry emissions, or 1,776 of the total 3,756 million metric tons (MMT) of industry emissions. Transportation and manufacturing each account for nearly a quarter of industry emissions.

The carbon footprint of some industries stems primarily from their use of fossil fuels. For other industries, it arises primarily from carbon embedded in the goods and services they purchase from other businesses. Carbon is embedded in the goods and services a company purchases when its suppliers use fossil fuels in the production of those goods and services.

The industry categories of electric power generation, transportation, manufacturing, agriculture, mining and construction have the highest direct emissions share. For the electric power generation and transportation industries, more than 90% of their carbon footprints result from their use of fossil fuels. In contrast, all of the other industry categories have a majority of their carbon footprint embedded in their supply chains. Within each industry, carbon footprints vary from company to company.

Comparing different industries that contribute similar overall amounts of emissions to the economy reveals how varied emissions sources can be. It also illustrates why strategies for addressing emissions need to be tailored to the specifics of each industry and company.

Notably, the carbon footprint of a company is often segmented into Scope 1, Scope 2 and Scope 3 emissions. This segmentation follows the Greenhouse Gas (GHG) Protocol typically used in ESG reporting. 

Case studies — two hypothetical companies

An examination of two hypothetical companies of the same size ($1 billion in annual sales) but in different industries — the truck transportation industry and the aluminum refining and production industry — further illustrates how greatly carbon footprints can vary based on specific company characteristics.

These two hypothetical companies have economic characteristics and carbon emissions representing the average of their respective industries. The estimates are derived from the EY Carbon Modeling Tool, which includes data and modeling of the economic characteristics and carbon emissions of more than 400 industries, as well as supply-chain modeling.

The increasing importance of ESG to consumers, employees and investors, as well as the increasing attention policymakers are paying to carbon mitigation policies, makes it more vital than ever for companies to understand their carbon footprint. Knowing the size of a company’s carbon footprint and its composition helps quantify its exposure from ESG reporting and carbon-related policy changes as well as identify potential focus areas for mitigation strategies. Company-specific financial modeling and scenario planning can be a helpful tool as companies work through these issues, engage with consumers, employees, investors and policymakers and prepare for a world with rapidly developing ESG reporting, carbon mitigation policies and environmental challenges.

About these estimates

The analysis of the two hypothetical companies was conducted using the EY Carbon Modeling Tool. Both companies are assumed to reflect the average characteristics of a company in their industry. The EY Carbon Modeling Tool is an input-output model (i.e., a quantitative economic model representing the interdependencies of different sectors in the economy). The model shows how the output of one industry may become an input to another through an inter-industry matrix, illustrating how dependent each industry is on the outputs of other industries. To determine an industry’s carbon footprint, this analysis relied on data on emissions by type and source from the U.S. Energy Information Administration. These data were mapped at a detailed level to industries defined by the Bureau of Economic Analysis and distributed with data on the degree to which each industry uses the source emission product in its production process.

The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms.

The increasing importance of ESG to consumers, employees and investors, and the increasing attention policymakers are paying to carbon mitigation policies, makes it more vital than ever for companies to understand their carbon footprint. Knowing the size of a company’s carbon footprint and its composition helps quantify its exposure from ESG reporting and carbon-related policy changes and identify focus areas for mitigation strategies. Company-specific financial modeling and scenario planning is a helpful tool as companies work through these issues, engage with consumers, employees, investors and policymakers and prepare for a world with ESG reporting, carbon mitigation policies and environmental challenges.

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• Implementing Tax

Minimum Tax Configuration Setup

Define the minimum tax configuration setup to handle the majority of your tax requirements. As part of defining transaction and withholding taxes, decide the direct and indirect tax rule defaults for the tax and set up the associated tax accounts.

For complex tax requirements, create tax rules that consider each tax requirement related to a transaction before making the final tax calculation.

Setting Up Direct Tax Rule Defaults

The direct tax rule defaults are the default values for the direct tax rule types, which include:

Place of supply

Tax applicability

Tax registration

Tax calculation formula

Taxable basis formula

The following table describes the direct tax rule defaults and examples:

Setting Up Indirect Tax Rule Defaults

The indirect tax rule defaults for a tax include:

Tax jurisdiction

Tax recovery rate

The following table describes the indirect tax rule defaults and examples:

Setting Up Tax Accounts

Set up tax accounts at the tax level. The application automatically copies the tax account combination to the tax rate accounts or tax jurisdiction accounts that you create for the tax for the same ledger and optionally, the same business unit. Any subsequent changes you make to existing tax accounts at the tax level aren't copied to the tax rate or tax jurisdiction level.

Define tax accounts at any of the following levels. The defaulting option is only available at the tax level.

Set up tax accounts for the following:

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