Knowledge Base

Direct and Indirect Taxes

The history of taxation dates back to ancient times. India, China, Egypt and other old civilizations have been imposing taxes in one form of the other since ages. Governments today impose taxes so that they may develop their nations. Indeed, if not for taxes, the government would have no money to spend on its people. Someone once said, “Taxes are the price we pay for a civilized society”. Well, we can argue if that is really true and whether the quality of life has indeed increased, but there is no denying that taxes exist and will continue to exist in one form or the other. All the taxes that we pay in India are backed by laws passed by either the Parliament or the State Legislature. The governments keep on modifying tax structures - a recent example in India being abolishing VAT and other taxes and replacing it by GST - but taxes are essentially formulated by either the state government of the central government.

There are many ways you can classify taxes. For the purpose of this article, we will be discussing direct and indirect taxes.

First, let’s define what direct and indirect taxes mean.

Direct taxes are those that a person pays to the government upfront. In India, direct taxes are implemented by an apex body called as Central Board of Direct Taxes. Typically, direct taxes are proportional to an entity’s income.

Indirect taxes are taxes that you pay to the government but are not levied directly by the government. If you avail of a service and the invoice includes some sort of tax, you are paying indirect tax. The intermediary later files a tax return and forwards the tax proceeds to government with the return. Despite all the reforms of recent years (notably the introduction of GST), the tax structure in India remains skewed and dominated by indirect taxes. In general, the share of government (State and Central) revenue from indirect taxes in India is about two-thirds, while that of the direct taxes is one-third.

Examples of Direct Taxes in India
Income tax: By far, income tax is the most common (and dreaded!) example of direct tax imposed by the government of India. Like the name says, it is tax paid by individuals and entities on the income they make. Usually, there is a certain limit up to which income is exempt from taxation, and the consequent amount is charged slab wise. Each budget addresses and revises this limit from time to time (both exemption limits and the slab percentages). On an average, the more you earn the more income tax you need to pay to the government. Agricultural income is exempt from income tax as per the provisions of the Constitution of India.

Corporate tax: The tax paid by companies on their income is called as the corporate tax. Both Indian as well as foreign entities are required by law to pay corporate tax. For Indian organizations, corporate tax is paid on their net profit. For foreign companies, it is charged on profits that are deemed to emanate from their India operations. The dividends, interest and royalties a company earns are taxed as well.

Capital Gains tax: For an individual, capital assets refer to anything of a value that the person owns and can be used for the purpose of investment. In the case of a company, the capital asset is anything that can be used for more than a year and is not intended to be sold or liquidated during the course of business operation.

Examples of Indirect Taxes in India
Goods and Services Tax (GST):
By far, the most important indirect tax is the GST. In its current form, the GST has replaced other taxes like Value Added Tax (VAT), sales tax, entry tax, Octroi, etc.

Customs Duty: This tax is to be paid to the government of India for certain products purchased from a different country and imported to India.

Merits and Demerits of Direct Taxes

What works for direct taxes...

  • First and foremost, direct taxes go straight to the government. This eliminates the need for any intermediately to file a return and eliminates delay.
  • In most cases, it is very easy to compute direct taxes. Since there is minimal ambiguity, there is a tendency for maximum compliance.
  • Direct taxes in most countries (including India) are proportional to their income slab. This is theoretically ideal for the growth of the society as a whole.
  • Direct taxes are easy to collect as it is a case of one –on – one interaction
  • Since entities know beforehand their tax liability, they can plan better

What works against direct taxes....

  • The most important deterrent to direct taxes is human psychology. Since they are typically proportionate to income, direct taxes dissuade people from earning too much and going into a higher tax bracket.
  • Direct taxes discourage investment for the same reason
  • It is a human tendency not to pay more. Direct taxes are visible for everyone, and people resent paying what they may feel are inordinately higher taxes

Merits and Demerits of Indirect Taxes

What works for indirect taxes...

  • Typically, indirect taxes are hidden. Most of the times you do not recognize them, or they are for something that appeal to you. For example, you pay indirect tax when you go to a restaurant, watch a movie, buy a car or purchase jewellery. However, you do not mind paying this tax as it is for a pleasurable activity.
  • Indirect taxes are smaller, and need to be paid as a lump sum (unlike direct taxes)

What works against indirect taxes...

  • The most important objection to indirect taxes is that they are to be paid equally by the rich and the poor. For many commodities, this can prove to be regressive. For example, for a farmer, the increase in cost of diesel by even 3% can make a huge impact as compared to a businessman driving a plush diesel car.
  • For the government, collection of indirect taxes is costly. The government needs mechanisms and checks to ensure that the indirect tax is collected properly
  • Another factor that works against indirect taxes is the harmful effect in making the allocation of resources inefficient and cause excess burden on the consumers

Whether they are direct or indirect, beneficial or not, taxes are here to stay. While computing tax payable by individuals is relatively easy, businesses need expert advice to guide them. It is possible to save taxes legitimately by planning properly. Even very small businesses stand to gain with proper tax advice. That is why it is important to hire a good tax consultant. A reputed tax consultant will save you money in the long run and bring tangible benefits to your organization.