Meaning and Characteristics

A direct tax is a type of tax where the liability to pay the tax and the actual burden or "pinch" of the tax falls on the same person or entity. The taxpayer pays the tax directly to the government and cannot legally shift this burden to someone else. Direct taxes are primarily linked to the taxpayer's ability to pay, making them a key instrument for achieving economic equity.

The fundamental nature of a direct tax is that it is non-transferable. For example, if the government levies an income tax on Mr. A, Mr. A himself has to bear the burden of this tax and pay it from his own pocket; he cannot pass on this specific tax liability to Mr. B.

Levied directly on income or wealth

Direct taxes are imposed directly on the income, profits, or wealth of individuals and corporations. They target the financial capacity of a person rather than a transaction. The tax is calculated as a percentage of the economic resources accrued or held by the taxpayer over a period.

• Tax on Income: This is a tax on earnings from various sources like salary, business profits, rent, and capital gains. It is a tax on the 'flow' of resources.
• Tax on Wealth: This is a tax on the 'stock' of resources. It is levied on the total value of assets held by a person on a specific date, such as property, shares, and jewellery.

Incidence and impact fall on the same person

This is the most crucial characteristic that distinguishes a direct tax from an indirect tax. To understand this, we need to define two terms:

• Impact: This refers to the immediate point of contact or the initial burden of the tax. It falls on the person from whom the government collects the tax.
• Incidence: This refers to the final resting place or the ultimate financial burden of the tax. It falls on the person who actually bears the cost of the tax and whose disposable income is reduced by it.

In the case of a direct tax, the impact and incidence are on the same person. The person legally responsible for paying the tax (impact) is also the one who ultimately bears its economic burden (incidence). For instance, an employee on whom income tax is levied (impact) cannot increase the price of their services to shift this burden to their employer; they bear the full cost (incidence).

General Characteristics of Direct Taxes

• Progressive Nature: They are generally progressive, meaning the rate of tax increases as the income or wealth of the taxpayer increases. This is based on the principle of "ability to pay."
• Reduces Inequality: By taxing the rich at a higher rate than the poor, direct taxes help in reducing the gap between the rich and the poor, promoting social equity.
• Certainty: The taxpayer knows with certainty how much tax they have to pay, and the government has a fair idea of the revenue it will collect.
• Elasticity: The revenue from direct taxes can increase or decrease automatically with changes in national income and wealth, making it an elastic source of revenue.
• Difficult to Evade (in theory): Since they are levied directly on individuals and entities, their income and wealth are tracked, making evasion more difficult compared to transaction-based taxes.

Examples of Direct Taxes in India

The direct tax structure in India is primarily governed by the Income Tax Act, 1961, and administered by the Central Board of Direct Taxes (CBDT).

Income Tax

This is the most significant direct tax in India. It is levied on the total income of a "person" earned during the previous financial year. The definition of a "person" under the Income Tax Act is very wide and includes:

• An Individual
• A Hindu Undivided Family (HUF)
• A Company
• A Firm
• An Association of Persons (AOP) or a Body of Individuals (BOI)
• A Local Authority
• Every Artificial Juridical Person

For individuals, the tax is levied at progressive slab rates. There are different slab rates for resident individuals below 60 years, senior citizens (60 to 80 years), and super senior citizens (above 80 years). The government also introduces different tax regimes (e.g., the Old and New Tax Regimes) with varying rates and deductions.

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Corporation Tax

Corporation tax is a tax levied on the net profits of domestic and foreign companies operating in India. It is a form of income tax but is levied on corporate entities. Under the Income Tax Act, 1961, companies are taxed at specific flat rates, which differ for domestic companies and foreign companies. The government also introduced a concessional tax regime for new and existing domestic manufacturing companies to boost investment.

Wealth Tax (abolished for individuals)

Wealth tax was levied under the Wealth Tax Act, 1957. It was a tax on the net wealth of individuals, HUFs, and companies. Net wealth was calculated as the aggregate value of certain specified assets (like urban land, buildings, jewellery, motor cars) minus the debts owed in relation to those assets. The tax was levied annually on the net wealth exceeding a certain threshold.

However, the Government of India abolished the Wealth Tax with effect from the financial year 2015-16 (Assessment Year 2016-17). The rationale given was that the cost of collecting the tax was very high, while the revenue yield was low. To compensate for the revenue loss, an additional surcharge of 2% was levied on the super-rich (individuals with an income of over ₹1 Crore).

Gift Tax (abolished)

Gift tax was levied under the Gift Tax Act, 1958. It was a tax on the act of giving gifts. The tax was payable by the donor on the value of gifts given by them during the year, exceeding a certain threshold.

The Gift Tax Act was abolished in 1998. However, to prevent tax evasion by disguising income as gifts, the provisions for taxing gifts were reintroduced into the Income Tax Act, 1961, under Section 56(2). Under the current law:

• Any sum of money or property received by an individual or HUF without consideration (i.e., as a gift), the aggregate value of which exceeds ₹50,000 in a year, is treated as "Income from Other Sources" and is taxable in the hands of the recipient.
• However, gifts received from relatives, on the occasion of marriage, or under a will or by way of inheritance are exempt from this tax.

So, while the separate Gift Tax Act is gone, the taxation of gifts continues, but now as part of the income tax and on the recipient, not the donor.

Meaning and Characteristics

An indirect tax is a tax levied on the consumption of goods and services rather than on the income or wealth of a person. The defining characteristic of an indirect tax is that the person legally responsible for paying the tax to the government can, and usually does, shift the burden of the tax to another person. The tax is collected by an intermediary (like a retailer or a manufacturer) from the person who ultimately consumes the goods or services and is then passed on to the government.

In essence, the "pinch" of the tax is not felt by the person who pays it to the government, but by the end consumer.

Levied on goods and services

Unlike direct taxes, which are levied on persons, indirect taxes are levied on transactions involving goods and services. The tax is triggered by a specific event, such as:

• The manufacture or production of goods (Excise Duty).
• The import or export of goods (Customs Duty).
• The sale of goods (Sales Tax/VAT).
• The provision of services (Service Tax).
• The 'supply' of goods or services (GST).

Because the tax is embedded in the price of the goods or services, consumers often pay it without even being aware of the exact amount of tax they are bearing.

Incidence and impact fall on different persons

This is the definitive test to identify an indirect tax. The concepts of 'impact' and 'incidence' are crucial here:

• Impact: The immediate liability to pay the tax. This falls on the manufacturer, service provider, or seller who is registered with the tax authorities.
• Incidence: The ultimate economic burden of the tax. This falls on the final consumer who cannot shift the tax any further.

In the case of an indirect tax, the impact and incidence are on different persons. The manufacturer (impact) collects the tax from the wholesaler, who collects it from the retailer, who finally collects it from the consumer. The final consumer (incidence) is the one whose pocket is ultimately lightened by the tax.

Can be shifted to the consumer

The ability to shift the tax burden is a key feature. A manufacturer or retailer treats the indirect tax they pay as a part of their business cost, which they recover by including it in the price of the product they sell. The tax travels down the supply chain, from producer to consumer, getting passed on at each stage. This is why indirect taxes are also known as consumption taxes.

General Characteristics of Indirect Taxes

• Regressive Nature: They are generally considered regressive because they affect the rich and the poor alike. Since they are levied on goods and services, and the poor spend a larger proportion of their income on consumption, the effective burden of indirect taxes is often higher on the poor.
• Wide Coverage: They have a very broad base, as almost everyone in a country consumes some goods or services. This allows the government to collect revenue from a large number of people.
• Convenience: They are convenient to collect as they are paid in small amounts at the time of purchase and are included in the price, so the taxpayer doesn't feel the direct pinch.
• Inflationary: Since indirect taxes increase the price of goods and services, high rates of indirect taxation can contribute to inflation.

Examples of Indirect Taxes in India

India undertook a major reform of its indirect tax system on July 1, 2017, by introducing the Goods and Services Tax (GST), which subsumed many previous indirect taxes. The system is administered by the Central Board of Indirect Taxes and Customs (CBIC).

Goods and Services Tax (GST)

GST is the most significant indirect tax in India today. It is a comprehensive, multi-stage, destination-based tax that is levied on every value addition. It has replaced numerous central and state indirect taxes to create a single, unified market. GST is levied on the "supply" of all goods and services, except for a few items like alcoholic liquor for human consumption and specified petroleum products.

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Customs Duty

Levied under the Customs Act, 1962, this is a tax on the import of goods into India and the export of goods from India. When goods are imported, a Basic Customs Duty (BCD) is levied on their value. In addition to BCD, imported goods are also subject to Integrated GST (IGST) to ensure they are taxed at the same rate as domestically produced goods. Customs duty serves the dual purpose of generating revenue and protecting domestic industries.

Excise Duty

Before GST, Union Excise Duty was a tax levied by the Central Government on the manufacture of goods. After the introduction of GST, the scope of Union Excise Duty has been limited to a few specific items:

• Petroleum products (petrol, diesel, ATF)
• Tobacco and tobacco products
• Alcoholic liquor for human consumption (levied by states as State Excise Duty)

The duty is paid by the manufacturer but is recovered from the buyers by including it in the price of the product.

Value Added Tax (VAT) - subsumed by GST

Before GST, VAT was a multi-point tax on the sale of goods levied by state governments. It replaced the earlier single-point Sales Tax. VAT was levied at each stage of the supply chain, but a credit (set-off) was allowed for the tax paid at the previous stage. This system avoided the "cascading effect" (tax on tax) of the old sales tax regime. State VAT was one of the major taxes that was subsumed into GST in 2017.

Service Tax - subsumed by GST

Service tax was an indirect tax levied by the Central Government on the provision of services. It was introduced in 1994 and its scope was gradually expanded to cover almost all services. The service provider was liable to pay the tax but would collect it from the service recipient. Service tax was also subsumed into GST on July 1, 2017.

Progressivity vs. Regressivity

The economic impact of a tax on society is critically evaluated based on whether it is progressive, regressive, or proportional. This classification depends on the relationship between the tax rate and the taxpayer's ability to pay, which is typically measured by their income or wealth. The choice between these systems reflects a government's policy goals regarding social equity and income redistribution.

Progressive Taxation: The Principle of Direct Taxes

A tax system is described as progressive when the rate of tax increases as the taxpayer's income increases. In simple terms, high-income earners pay a larger percentage of their income in taxes than low-income earners. This system is founded on the principle of ability to pay, which posits that those with greater financial capacity should contribute more to the state's revenue.

Direct taxes, especially personal income tax, are designed to be progressive. The Indian income tax system, with its slab rates, is a classic example.

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Regressive Taxation: The Effect of Indirect Taxes

A tax is considered regressive when the tax burden falls more heavily on low-income individuals than on high-income individuals, relative to their income. The tax rate is uniform for all, but it consumes a larger proportion of a poor person's income compared to a rich person's income.

Indirect taxes, like GST, are inherently regressive. A 12% GST on soap is the same for a millionaire and a daily-wage labourer. Since the poor spend a much larger percentage of their income on basic consumption, the tax on these goods has a greater relative impact on them.

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Comparison Table

Impact on inflation and consumption

Taxes are a primary tool of fiscal policy used by governments to manage the economy. The choice between direct and indirect taxes, and the decision to raise or lower them, has a direct and significant impact on macroeconomic indicators like consumption and inflation.

Impact of Direct Taxes

On Consumption and Demand

Direct taxes directly affect the disposable income of individuals and the post-tax profits of corporations. Disposable income is the amount of money that households have available for spending and saving after income taxes have been accounted for.

• Increase in Direct Tax: When income tax rates are increased, individuals are left with less disposable income. This reduction in purchasing power leads to a decrease in overall demand for goods and services, particularly non-essential or luxury items.
• Decrease in Direct Tax: Conversely, a cut in income tax rates boosts disposable income, encouraging consumers to spend more. This stimulates aggregate demand and can help revive a sluggish economy.

On Inflation

Inflation is a state of rising prices, often caused by "too much money chasing too few goods" (demand-pull inflation). Direct taxes can be used as a tool to control this.

• Curbing Inflation: By increasing direct taxes, the government can withdraw excess purchasing power from the economy. The resulting decrease in aggregate demand helps to alleviate pressure on prices, thus acting as an anti-inflationary measure.
• Potential Risk: A drastic tax cut when the economy is already operating at full capacity can fuel inflation by over-stimulating demand.

Impact of Indirect Taxes

On Consumption and Prices

Indirect taxes are included in the market price of goods and services. Their impact on consumption is driven by this price effect.

• Increase in Indirect Tax: An increase in GST or excise duty on a product makes it more expensive for the final consumer. This can lead to a fall in the demand for that specific product. The government often uses high indirect taxes on items like tobacco and luxury cars (called 'sin taxes' or demerit goods) to deliberately discourage their consumption.
• Decrease in Indirect Tax: A reduction in GST on certain items, like electronics or automobiles, makes them cheaper and can spur their demand, providing a boost to those specific sectors.

On Inflation

Indirect taxes have a direct and immediate impact on the price level. This is a form of cost-push inflation.

• Fueling Inflation: When the government announces a hike in GST rates across the board, the retail prices of most goods and services increase overnight. This can lead to a one-time jump in the general price level and can trigger an inflationary spiral if wages also start rising in response.
• Controlling Effect: While less common, a general cut in indirect tax rates can have an immediate anti-inflationary effect by making goods cheaper.

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