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Comparison between Direct and Indirect Taxation

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Learn about the comparison between Direct and Indirect Taxation.

1. Direct Taxation:

Examples of direct taxation include income tax, corporation tax (on companies’ profits), capital gains tax (a tax on the profits of sales of certain assets), wealth tax (imposed by certain countries, which is a tax on ownership of property or wealth) and a cap­ital transfer tax (a tax on gifts to replace death du­ties). Direct taxes are mainly collected by the central government.

Advantages:

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(i) It is easy to determine the incidence of the tax—a person or institution who actually pays and suffers the burden of tax.

(ii) Direct taxes tend to be progressive—people in the higher income group pay a greater percentage than poorer people, e.g., income tax is graduated so that high income earners pay a larger percent­age; also a projected wealth tax would only apply to those owning more than a certain level of wealth.

(iii) Direct taxes tend to be cheap and easy to collect. Consider, for example, the PAYE system which is used to collect income tax from most wage and salary earners.

(iv) Direct taxes are important to government economic policy—if the government is fighting in­flation it can impose, for example, high levels of in­come tax to restrict consumer demand. If the gov­ernment is concerned about unemployment it can reduce the levels of income tax to increase consumer demand and increase production.

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Disadvantages:

(i) Direct taxation may be a disincentive to hard work. High rates of income tax, for example, may discourage people from working overtime or trying to gain promotion at work. Some economists blame the ‘brain drain’ (i. e, the emigration of highly qual­ified persons, such as scientists and doctors) on In­dia’s high levels of taxation.

(ii) Direct taxation discourages savings because, after paying taxes, individuals and companies have less income available to save. This means that in­vestment, which relies on the level of savings, is low and this could cause less production and em­ployment.

(iii) This type of taxation encourages tax evasion to avoid paying tax certain individuals may emi­grate or employ tax consultants or accountants to ad­vise them on how they could avoid paying so much tax.

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(iv) There is no element of choice about paying the tax it is unavoidable.

2. Indirect Taxation:

Examples of indirect taxation include customs duties, motor vehicle tax, excise duty, octroi tax and sales tax. Indirect taxes are collected both by the Central and State Governments but mainly by the Central Government.

Advantages:

(i) It is fairly easy to collect.

(ii) It is easy to determine the incidence of tax.

(iii) The government can use it to discourage certain types of consumption. A high rate of tax on tobacco can, for example, affect smoking habits.

(iv) Indirect taxation is a good way of raising rev­enue when levied on goods with an inelastic demand, such as necessities.

(v) Visitors spend money on goods and services in shops. This will increase tax revenues.

(vi) Consumers have a choice as to whether they pay the tax. They can avoid paying the tax by not consuming the goods which is being taxed,

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(vii) Indirect taxation does not have a disincentive effect on work.

Disadvantages:

(i) Indirect taxes are, regressive. A regressive tax is a tax which causes a poor person to pay a higher percentage of his or her income as tax than a rich person. For instance, the tax incidence of the price of a new television set would be the same for the poor and the rich person, but, as a percentage of the poor person’s income, it is far greater.

(ii) These taxes are not impartial. In recent years, certain groups of consumers have complained that they are being heavily penalised by taxation, e.g., drinkers, smokers and drivers.

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(iii) Indirect taxes may contribute to inflation. The imposition of an indirect tax on an item will in­crease its price, which is, in itself, inflationary. How­ever, this may set off an inflationary spiral as trade unions demand higher wages to maintain the real incomes of workers.

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