Difference Between Direct Tax vs Indirect Tax

Introduction

Direct taxes and indirect taxes are two types of taxes that are imposed by the government.

Direct taxes are taxes that are paid directly by individuals or organisations to the government. These taxes are based on the income or profits earned by the taxpayer.  

Indirect taxes are taxes that are imposed on goods and services and are passed on to the end consumer. These taxes are included in the price of the goods or services being sold and are paid indirectly by the consumer.  

This article aims to provide basic concepts in taxation and help readers differentiate between direct and indirect tax. 
 

What Is Direct Tax?

A direct tax is a type of tax that is imposed by the government on individuals or organisations based on their income, profits, or assets. Direct taxes are paid directly by the taxpayers to the government and cannot be shifted to others.  Examples of direct taxes include income tax, corporate tax, and wealth tax.

Direct taxes are usually progressive in nature, which means that the tax rate increases as the income or profits of the taxpayer increase. This is done to ensure that those who earn more pay a higher proportion of their income as tax, to promote income equality and redistribute wealth.

Direct taxes play a significant role in the economy as they provide a source of revenue for the government, which can be used to fund public goods and services such as infrastructure, healthcare, and education. Direct taxes also help to promote fiscal discipline and reduce income inequality by ensuring that those who have higher incomes or profits contribute a larger share of their wealth towards public services and social welfare.
 

What Is Indirect Tax?

An indirect tax is a type of tax that is levied on goods and services rather than on individuals or organisations directly. Indirect taxes are embedded in the price of goods and services and are ultimately paid by the end consumer.  Examples of indirect taxes include sales tax, excise duty, customs duty, and value-added tax (VAT).

Indirect taxes are generally regressive in nature, which means that the tax burden falls more heavily on low-income individuals or households, as they tend to spend a larger proportion of their income on goods and services. This can have an impact on income inequality and may disproportionately affect vulnerable or marginalised populations.

Indirect taxes play an important role in the economy as they provide a significant source of revenue for the government, which can be used to fund public goods and services. Indirect taxes also have the potential to influence consumer behaviour and promote economic efficiency by incentivizing individuals to consume less of certain goods or services that are heavily taxed.

Comparison: Direct Tax Vs Indirect Tax

Being able to differentiate between direct and indirect taxes is essential for understanding their implications on individuals, organisations, and the broader economy.
 

Types: Direct Tax Vs Indirect Tax

India has several types of direct and indirect taxes, which are levied by the central and state governments.

Direct taxes in India include:

1.    Income Tax: A direct tax levied by the central government on the income earned by individuals and organisations in a financial year.
2.    Corporate Tax: A direct tax levied on the profits earned by companies in a financial year.
3.    Capital Gains Tax: A direct tax levied on the profit earned from the sale of an asset, such as property or shares, held for a certain period.
4.    Wealth Tax: A direct tax levied on individuals and Hindu Undivided Families (HUFs) with a net wealth exceeding a certain threshold.

Indirect taxes in India include:

1.    Goods and Services Tax (GST): An indirect tax levied on the supply of goods and services, intended to replace several indirect taxes levied by the central and state governments.
2.    Customs Duty: An indirect tax levied on goods imported into India from other countries.
3.    Excise Duty: An indirect tax levied on goods manufactured in India, intended to be sold within the country.
4.    Entertainment Tax: An indirect tax levied on various forms of entertainment, such as movies, concerts, and sports events.
5.    Service Tax: An indirect tax levied on services provided within the country, such as banking, insurance, and telecommunication services.
6.    Value-Added Tax (VAT): A value-added tax (VAT) is a type of indirect tax that is imposed on the value added to a product or service at each stage of its production or distribution.

The most significant among these taxes is the GST, which was introduced in July 2017 and replaced several indirect taxes previously levied by the central and state governments. The GST is a comprehensive indirect tax levied on the supply of goods and services and has significantly simplified the taxation system in India.

Apart from these, India also levies a variety of other taxes such as property tax, professional tax, and stamp duty, among others, which are imposed by the state governments.
 

How To Calculate Direct Taxes?

The calculation of direct taxes depends on the specific tax being calculated.

For instance, in the case of income tax, the calculation involves the following steps:
1.    Calculate the gross income earned by the individual or organisation.
2.    Deduct any applicable tax exemptions and deductions from the gross income.
3.    The remaining income is known as taxable income.
4.    Determine the tax slab under which the taxable income falls and apply the corresponding tax rate to calculate the income tax payable.
5.    Deduct any applicable tax credits from the income tax payable to arrive at the final income tax liability.

In the case of corporate tax, the calculation involves the following steps:
1.    Calculate the net profit earned by the company in a financial year.
2.    Deduct any applicable tax exemptions and deductions from the net profit to arrive at the taxable income.
3.    Determine the tax rate applicable to the company based on its legal structure and apply the corresponding tax rate to calculate the corporate tax payable.

It is important to note that the tax laws and rates are subject to change, and individuals and organisations are advised to consult a tax professional for specific advice on calculating their direct taxes.

How To Calculate Indirect Taxes?

The calculation of indirect taxes depends on the specific tax being calculated.

For instance, in the case of Goods and Services Tax (GST), the calculation involves the following steps:
1.    Determine the taxable value of the goods or services being supplied.
2.    Identify the GST rate applicable to the goods or services based on their classification under the GST law.
3.    Calculate the GST payable by multiplying the taxable value with the applicable GST rate.
4.    If eligible, deduct any available input tax credit from the GST payable to arrive at the final GST liability.

In the case of customs duty, the calculation involves the following steps:
1.    Determine the value of the imported goods in Indian Rupees.
2.    Identify the customs duty rate applicable to the imported goods based on their classification under the customs law.
3.    Calculate the customs duty payable by multiplying the value of the imported goods with the applicable customs duty rate.

It should be kept in mind that tax laws and rates are prone to change, and it is recommended that individuals and organisations seek guidance from a tax expert for precise advice on computing their indirect taxes.
 
 

Benefits: Direct Tax Vs Indirect Tax

Direct Taxes:

1.    Direct taxes promote income equality and redistribution of wealth.
2.    Direct taxes ensure those who earn more pay a higher proportion of their income as tax.
3.    Direct taxes provide a significant source of revenue for the government, which can be used to fund public goods and services. Direct taxes can promote fiscal discipline and help reduce the government's fiscal deficit.
4.    Direct taxes can be used to encourage certain behaviours, such as investment in specified sectors or donations to charitable causes.
5.    Direct taxes can be used to control inflation by reducing the disposable income of individuals and curbing excess demand. 
6.    Direct taxes can be used to promote long-term savings and investment by providing tax benefits on specific investment instruments.
7.    Direct taxes can promote transparency and accountability in the tax system, as taxpayers can easily see how much they owe in taxes and how their taxes are being utilised by the government.

Indirect Taxes:

1.    Indirect taxes are easier to administer and collect than direct taxes.
2.    Indirect taxes provide a significant source of revenue for the government, which can be used to fund public goods and services.
3.    Indirect taxes have the potential to influence consumer behaviour and promote economic efficiency by incentivizing individuals to consume less of certain goods or services that are heavily taxed. 
4.    Indirect taxes can be adjusted to generate revenue in times of economic growth or recession.
5.    Indirect taxes can be used to promote social causes, such as environmental protection or public health, by imposing taxes on products that are deemed harmful.
6.    Indirect taxes can be used to simplify the tax system by consolidating multiple taxes into a single tax, such as the Goods and Services Tax (GST) in India.
7.    Indirect taxes can be used to promote economic growth by reducing the tax burden on businesses and encouraging entrepreneurship.
8.    Indirect taxes can be used to improve tax compliance, as it is easier to track and monitor indirect tax payments than direct tax payments.
 

Disadvantages: Direct Tax Vs Indirect Tax

Direct Taxes 

1.    Direct taxes can be complex and difficult to understand, which can lead to errors in tax calculation and payment.
2.    Direct taxes can be regressive, as they may have a larger impact on low-income individuals than on high-income individuals.
3.    Direct taxes can lead to tax evasion and avoidance, as individuals and organisations may find ways to hide their income or shift it to lower tax jurisdictions.
4.    Direct taxes can be politically unpopular, as they may be seen as burdensome or unfair by some taxpayers.
5.    Direct taxes can be disruptive to business activity, as they can affect the cost of labour and the profitability of businesses.
6.    Direct taxes can discourage investment and savings by reducing the disposable income of individuals and businesses.

Indirect Taxes 

1.    Indirect taxes can be regressive, as they may have a larger impact on low-income individuals than on high-income individuals.
2.    Indirect taxes can lead to an increase in the cost of living, as the prices of goods and services may go up due to the tax.
3.    Indirect taxes can lead to inflation, as the increase in the cost of goods and services may lead to an increase in demand and supply, which in turn can lead to higher prices.
4.    Indirect taxes can be complex and difficult to administer, which can lead to errors in tax collection and payment.
5.    Indirect taxes can be subject to tax cascading, where tax is paid on tax, which can increase the overall tax burden.
6.    Indirect taxes can discourage consumption and lead to a decrease in demand for goods and services.
 

Conclusion

We hope that after reading this article you can now differentiate between direct and indirect tax. Both direct and indirect taxes have their own set of advantages and disadvantages. Direct taxes promote income equality and provide a significant source of revenue for the government, but they can be complex and politically unpopular. Indirect taxes are easier to administer and can influence consumer behaviour, but they can increase the cost of living and lead to inflation.  

Ultimately, the choice between direct vs indirect tax depends on the economic priorities of the government and the specific needs of the country. A balanced tax system that takes into account the benefits and drawbacks of both types of taxes can help promote economic growth and stability.