Direct and Indirect Tax

Taxes are mandatory fees collected by governments to fund development. In India, you pay taxes on your income and on goods and services. These are categorized as direct taxes (income tax) and indirect taxes (GST, customs duty, etc.).

As responsible and informed taxpayers, you should know the differences between direct and indirect taxes.

Taxes are basic sources of revenue for the government. Depending on how they are collected, taxes can be categorised as direct and indirect taxes. Let’s understand each type of tax in detail below:

1. Direct tax

Direct tax is a type of tax that’s paid directly by the taxpayer to the government. For direct taxes, the tax burden is borne by the individual on whom the tax is levied. In other words, the taxpayer cannot transfer this tax liability to another person. It is generally collected from the taxpayer's annual net income or earnings. In India, direct taxes fall under the purview of the Central Board of Direct Taxes (CBDT) which is in turn governed by the Department of Revenue.

Here are a few examples of direct taxes in India:
 

A. Income tax

Income tax is a direct tax imposed on the annual income of the taxpayer if their earnings fall under the income tax brackets instituted by the government. Income tax is collected at slab rates.
 

B. Corporate tax

Companies incorporated in India are liable to pay this direct tax to the Indian government. Corporate tax is collected at a flat rate on the business’s net profit in the relevant financial year.
 

C. STT

STT or the Securities Transaction Tax is a direct tax levied on the sales and purchase of equity securities listed on recognised stock exchanges.
 

2. Indirect tax

Indirect tax is a type of tax that taxpayers pay to the government through an intermediary. The intermediary collects the tax amount and then passes it on to the government. Indirect taxes are transferable taxes since the tax burden can be shifted to others. For instance, if the government imposes an indirect tax on a service provider, this tax burden is passed on to the end consumer, who finally pays it. Indirect taxes fall under the administrative purview of the Central Board of Indirect Taxes (CBIC), which operates under the Department of Revenue.

Here are a few examples of indirect taxes in India have previously existed in India:

• Sales tax
• Custom duty
• Excise duty
• Service tax
• VAT

These indirect taxes were subsumed and replaced by the GST or the Goods and Services Tax in 2017. The introduction of GST helped eliminate the cascading effect of multiple indirect taxes and streamline the indirect tax collection process.

A. Individuals:
 

1. Direct Taxes

Higher-income individuals may face higher tax rates, but they can benefit from tax reliefs and deductions. Direct taxes are more transparent, allowing individuals to plan their finances better.
 

1. Indirect Taxes

Affect all consumers equally based on their consumption patterns. Lower-income individuals may bear a heavier burden due to higher relative spending on taxed goods.
 

B. Businesses:
 

1. Direct Taxes

Companies must manage their tax liabilities and ensure compliance with tax laws, which can involve complex calculations and substantial paperwork.
 

2. Indirect Taxes

Businesses collect indirect taxes from consumers and remit them to the government. Compliance requires accurate tracking of sales and taxes on goods and services.

Types of direct taxes in India are:

• Income tax: This is the most common direct tax, levied on individuals and businesses based on their annual income.
• Capital gains tax: This tax is imposed on profits made from selling assets like property or investments.
• Securities transaction tax (STT): This tax is applicable on every transaction involving the buying or selling of securities.

Benefits of direct taxes:

• Progressive in nature, ensuring fairness by taxing based on income level.
• Helps in reducing income inequality, as higher earners contribute more.
• Provides transparency and easier monitoring for tax compliance.
• Encourages savings and investment as certain exemptions are available.

Benefits of indirect taxes:

• Collected on goods and services, ensuring a broader tax base.
• Simple to administer and provides a consistent revenue stream.
• Spread across all consumers, distributing the tax burden.
• Not directly linked to income, which encourages saving and investment.
• Helps reduce tax evasion as it is collected at the point of sale.

Drawbacks of direct taxes:

• Can discourage high earnings and investments due to higher tax rates.

• Complex tax filing procedures can burden taxpayers.

• Higher administrative costs for collection and compliance.

• Direct taxes may lead to tax evasion if individuals underreport income.

Drawbacks of indirect taxes:

• Regressive in nature, disproportionately affecting lower-income individuals as they pay the same rate as higher earners.

• Can increase the cost of essential goods and services, leading to inflation.

• Indirect taxes are less visible, making it harder for consumers to understand how much they are paying in taxes.

• May reduce overall consumption, especially among price-sensitive consumers.

Both direct and indirect taxes play crucial roles in the economic framework, each with its benefits and drawbacks. Direct taxes are more transparent and equitable but can be complex and discourage earnings. Indirect taxes are broader and easier to collect but can be regressive and hidden in consumer prices. Understanding these differences helps individuals and businesses navigate their financial responsibilities and plan their tax strategies effectively.