What is the Difference between Direct Tax and Indirect Tax?

Most people know about taxes as they are deducted regularly from their salary and charged while buying or consuming something. But have you tried to differentiate GST from corporate tax? Direct and indirect taxes are two broad categories of taxes imposed on taxpayers to collect revenue for a country’s development.

Direct taxes are levied directly on individuals or entities and are based on their income or profits, such as income tax. Indirect taxes, on the other hand, are imposed on goods and services, affecting the final consumer, and include taxes like sales tax and value-added tax (VAT). You are at the right place if you also want to know more about direct and indirect taxes.

Understanding Direct Tax

A direct tax is a tax that a person or organization pays directly to the entity that imposed it. As this type of tax is directly imposed by the government, it cannot be transferred to another entity. Some advantages of direct tax are that it aids in curbing inflation and distributing wealth equally in society.

Types of Direct Taxes in India

Several types of direct taxes are levied by the central government. Let’s take a look at some of the most common forms of direct taxes.

Income Tax

Income tax is a common tax paid by most salaried and self-employed persons. This tax varies from person to person as one pays income tax according to the tax bracket in which their income is directly levied on the salary. Besides, the Government of India allows taxpayers income tax exemption for various investments and expenditure schemes.

Wealth Tax

Wealth tax is levied on the value of certain assets in the market for that particular financial year. Individuals, HUFs (Hindu Undivided Family), or companies can hold this asset. Though wealth tax was widely used before, now it has been abolished.

Corporate Tax

Corporate tax is levied on the profits of companies and businesses in India. This tax also applies to foreign companies where the income arises from India.

Capital Gains Tax

Capital Gains tax is taxed on the income from the sale of investments. The tax is levied based on how long you hold the asset. Capital gains are of two types, Long-term Capital gains (LTCG) and short-term capital gains (STCG), according to which the tax rates differ.

What is the Difference Between Direct and Indirect Taxes?

Understanding the differences between direct and indirect taxes is essential to improve your budget planning.

Benefits of Direct Tax

The advantages of direct taxes extend beyond mere revenue generation, playing a pivotal role in shaping a fair, transparent, and socially responsible fiscal policy. Here are some benefits of direct taxes:

Help Control Inflation

Direct taxes can influence the demand for goods and services and help keep inflation in check. In case of a rise in the inflation rate, the government increases direct taxes. With rising taxes, the demand for goods and services falls, and inflation is controlled.

Promote Equality

Direct taxes are directly proportional to the income of the payer. So, people with a high income pay higher direct taxes, and people with a lower income pay lower direct taxes. These taxes help maintain equality.

Benefit the Underprivileged

The tax collected by higher-income people is used to provide better facilities and initiatives to people experiencing poverty. It stabilizes income inequality and helps lower-income groups in their day-to-day lives.

How are Direct Taxes Collected in India?

The government typically collects direct taxes through a system of self-assessment. It means that taxpayers are responsible for calculating and paying their taxes. However, the government may also collect direct taxes through withholding at the source, which means that the tax is withheld from the taxpayer’s income or assets before it is paid to them.

Disadvantages of Direct Tax

Like two sides of a coin, there are some disadvantages to direct taxes as well:

Can Lead to Fraud And Tax Evasion

Direct taxes are paid by the country’s citizens, just like income tax. Since this is an obligatory tax, some people may try fraud to avoid paying them.

Can Lead to Disputes Between Different Income Groups

Since direct taxes are paid as per the income, high-income groups can feel overburdened. Similarly, lower-income groups may sense the economic divide that leads to social inequality.

Can be Inconvenient

Unlike indirect taxes, direct taxes are not included in the price of goods or services. They can come with their fair share of paperwork that can seem troublesome.

Can Discourage People from Investing

Capital gains taxes may lead people to avoid investments to reduce their tax liability. This further disrupts the economy’s growth and hampers the individual’s financial health.

Understanding Indirect Tax in India

Indirect tax is a tax the government imposes on the supply of goods and services that can be transferred from one entity to another. Recently, the government introduced the Goods and Services Tax (GST) on 1 July 2017, which subsumed all the other kinds of indirect taxes. Some of the benefits of GST as an indirect tax are the elimination of a diversity of taxes and an eventual decrease in the cost of goods due to the reduction in the cascading effect of taxes.

Types of Indirect Tax

All the taxes you pay on things or services you purchase come under indirect taxes. They are of different types, such as:

Goods and Services Tax (GST)

GST is charged twice where the Central Government levies Central GST (CGST) and the State Government levies State GST (SGST) on intra-state supply of goods or services. The Centre also levies Integrated GST (IGST) on the inter-state supply of goods or services.

Tax on Liquor and Petrol Products

Taxes on liquor and petrol products do not come under GST and are taxed separately. The government earns a mouthful of revenue through these taxes.

Benefits of Indirect Tax

Indirect taxes are imposed on goods and services. But is there any benefit of imposing indirect taxes on goods and services? Let us know about some benefits of indirect taxes:

Promote Equal Participation

Since indirect taxes are the same for all citizens, everyone contributes to indirect taxes irrespective of income.

Easy to Pay Off

No heavy paperwork is involved in paying indirect taxes. The collection happens at the time of the sale and is paid to the government by the supplier.

Help Create Awareness

Indirect taxes charged on harmful substances, such as alcohol, cigarettes, etc., are considerably higher than other routine products. This creates awareness and discourages people from using such products.

Affordable

Indirect taxes are usually included in the price of the product or service, which is why they do not appear as high. People simply pay them when they make a purchase. There is no separate payment.

Disadvantages of Indirect Tax

Some disadvantages of indirect taxes are:

There is no awareness of the tax amount

Indirect taxes are included and hidden in the price of the goods or services purchased. Hence, people do not always know how much tax they pay to the government.

They are the same for every income group

Indirect taxes remain the same for all, irrespective of the income. This implies that people from a lower-income group will pay the same indirect tax on a product or service as people from a higher-income group. This may be equal, but it is not equitable.

They add to the price of goods

Indirect taxes increase the price of goods and services for the local people. They end up paying a higher price than the product’s original price, and these taxes ultimately interfere with their monthly budgetary constraints.

Wrapping Up

Direct and indirect taxes serve distinct purposes within a tax system, addressing the diverse revenue needs of a government. While direct taxes aim to distribute the tax burden based on individual income and wealth, indirect taxes focus on consumption patterns. A well-balanced tax system often incorporates a mix of both types, allowing governments to achieve fiscal goals while minimizing adverse effects on economic growth and individual welfare. Understanding the differences between direct and indirect taxes is essential for individuals, businesses, and policymakers navigating the intricate landscape of taxation.

Key Takeaways

• The central government imposes direct taxes on individuals and entities based on their income or profits earned.
• Direct taxes can influence the demand for goods and services and help keep inflation in check.
• Indirect tax is a tax the government imposes on the supply of goods and services.
• Since indirect taxes are the same for all citizens, everyone contributes to indirect taxes irrespective of income.