A tax is a compulsory monetary charge or some other type of levy that is usually imposed by the government or municipality to individual incomes, business profits, or added on some goods that are bought by the consumers. The money raised through taxation is used to fund various government expenditures, which include hospitals and construction of infrastructures among others. Direct and indirect taxes comprise some of the taxes that the government charges. However, there exist significant differences between direct and direct taxes as discussed below.
What is a Direct Tax?
A direct tax is the money paid directly to the imposing authority which most of the time is the government or the municipal authority. Examples of direct taxes include the income tax, the corporate taxes, property taxes, and gift taxes.
What is an Indirect Tax?
An indirect financial charge that is collected by an intermediary from the ultimate bearer of the cost. The intermediary files a tax return later and submits the collected amount to the imposing authority or government. Some of the examples of indirect taxes include the value-added tax, the central tax, customs duty, service tax, and securities transaction tax among others.
Difference Between Direct and Indirect Taxes
One of the major difference between direct and indirect tax is that direct tax is progressive while the indirect tax is retrogressive. This means that direct tax increases with the amount that is available for taxation while indirect tax reduces the amount that is available for taxation. People have therefore developed a concept that indirect taxes are bad and are geared towards discouraging people from working hard while indirect taxes are good because they encourage people to spend more so that they can be spared significant amount of money with respect to their spending capability.
- Incidence and Impact
The second difference is that direct taxes happens and effects one person while indirect taxes happens from a different person while the impact is felt by another. This is because the direct taxes are charged on the income of an individual, income of the company, or taxes or property owned. On the other hand, indirect taxes are received from an individual who is not the ultimate cost bearer. The individual collecting indirect taxes act as an intermediary with the sole purpose of collecting the taxes and later delivering them to the government.
The third difference is that one can evade from paying direct taxes while it is difficult for one to evade paying indirect taxes. People can fail to disclose their incomes and thereby not paying income taxes. Moreover, organizations have specific strategies that they use so that they can evade direct taxes to the government like declaring zero profits, paying much of their profits in dividends, or having huge debenture loans upon which the government is forced not to tax them. However, it is complicated for individuals or organizations to evade payment of indirect taxes because they are attached to most of the goods and services that people buy. This means that every time a person purchases a product or a service, he or she pays an indirect tax.
- Transfer of Burden
There exists a profound difference in that direct taxes cannot be transferred while indirect taxes can be shifted form one person to another. It is challenging for one to shift income tax obligations from one person to another or from one person to another which means that one will ultimately pay for those charges. This is not the same for indirect taxes, which can easily be transferred or shifted from one person to another. A retail outlet, which is charged value added tax by the government, shifts that burden to the final consumer of the products is hence protecting itself against the payment of indirect taxes.
- Impact on Inflation
Both direct and indirect taxes have different impacts on inflation. Direct taxes help in lowering inflation within the economy because they reduce the purchasing power of individuals but getting a significant proportion of their incomes. This results in a fall in aggregate demand because people do not have disposable income that they can use to demand goods and services available in the market. On the other hand, indirect taxes play a significant in increasing inflation within the economy. Since the more people purchase, the less the indirect taxes they will pay, they are therefore encouraged to purchase more leading to an increase in aggregate demand that can result to inflation if there is no proportionate supply of goods and services demanded.
- Costs Involved in Collection
Costs and techniques involved in the collection of indirect taxes are less because there are definite collection points and only a certain percentage is deducted from the person buying goods and services. This is not the same in direct taxes because they involve many deductions which sometimes can be costly and time-consuming. Tax collection authorities have always had the preference of collecting indirect taxes as compared to the preference of collecting direct taxes due to costs and labor involved.
- Collection Coverage
Despite being easy and less technical to collect, indirect taxes cover a wide coverage and a huge number of people because they are taxed on any person buying goods and services that are highlighted in the value-added tax bracket. However, direct taxes cover a small proportion of people who are employed because it is charged on income. Besides, very few organizations are taxed because many businesses are registered as sole proprietors, and they are taxed together with the income of the individual while some are not even registered making it hard to tax them.
A Summary of Differences Between Direct and Indirect Taxes
|Direct Taxes||Indirect Taxes|
|Incidence and Impact Fall on one person||Incidence and impact falls on different persons|
|Can easily be evaded||Difficult to evade|
|One cannot shift the burden||One can shift the burden to another party|
|Reduces Inflation||Increases inflation|
|Costly to collect||Cheap and easy to collect|
|Narrow coverage||Wider coverage|
- Indirect contributions are oriented more towards growth as they discourage consumption and help enhance savings. Direct taxes, on the other hand, reduce savings and discourage investments.
- Additional indirect taxes charged on harmful commodities such as cigarettes, alcohol, etc. dissuades over-consumption, thereby helping the country in a social context.
- Direct taxes help in reducing disparities and are considered to be progressive while indirect taxes enhance inequalities and are considered to be regressive.