Let us learn about the merits and demerits of direct tax in economics.
Merits of Direct Tax:
Direct taxes have some important merits:
(a) Canon of Ability to Pay Satisfied:
Direct tax is imposed in accordance with the ability of taxpayer to pay so that the burden of taxation is distributed among the taxpayers in a just or equitable manner. Thus, it satisfies the Smithian canon of ability to pay or canon of equality to pay taxes and the least aggregate sacrifice.
A direct tax is progressive in effect. The rates of direct taxes are fixed in such a way that the rich people with higher income pays higher rate of taxes compared to people with lower income.
Such a system of taxation observes the principle of progressive taxation. Being progressive in nature, direct tax can serve as a means of reducing inequalities in the distribution of income and wealth. Social equity can be established by levying direct taxes.
(c) Certain Tax Burden:
The burden of this tax is certain to the taxpayer. A salaried person knows beforehand when, where, and how much taxes are to be paid. Such certainty enables taxpayers to make provision of the payment of tax in advance. Further, the government is almost certain of the revenue yield from direct taxes and, accordingly, it can prepare its plans for financing Five Year Plans.
(d) Economical, Productive and Elastic:
Direct taxes are economical, elastic and productive. It is economical in the sense that the costs of collecting these taxes are comparatively lower since these are mostly collected annually in lump-sum and at source. Since employers are legally responsible for collecting income taxes from their employees the cost of collection of such tax is almost nil.
It is elastic in the sense that the government can change rate of taxes according to its needs. Whenever income or wealth rises, the government takes appropriate measures to increase the rates of direct taxes.
It is revenue-yielding since the cost of collecting tax is low.
Above all, direct taxes act as automatic stabilizers in the sense that the amount of tax revenue rises when economic growth takes place and declines when national income declines. In this way, it removes ‘inflationary heat’ as well as ‘depressionary impact’ from the economy.
(e) Arousing Civic Consciousness:
It arouses civic consciousness among the taxpayers. When people are fully aware of the payment of taxes, they take active interest in the way the public revenue is spent. They resent wasteful government expenditures. Such civic consciousness acts as a safety valve against incurring reckless expenditures by the government in a democratic country.
(f) Important Anti-Inflationary Measure:
Finally, direct taxes can control inflationary tendencies. Inflation in an economy is caused by the interplay of various factors. Most important among them is the increase in aggregate demand or aggregate expenditure. Consumption, investment and government expenditures constitute aggregate expenditures.
Such expenditures can be curtailed by raising the rate of taxes on income. This will result in a decline in disposable income. Fall in disposable income means, therefore, fall in aggregate expenditures. Thus, direct taxes serve as an important anti-inflationary instrument.
Demerits of Direct Taxes:
Direct taxes, however, are not free from disadvantages:
(a) Difficulty in Measuring Ability to Pay:
It is difficult, if not impossible, to measure the ability to pay of each and every taxpayer since ability to pay taxes is not governed alone by income or wealth of an individual. A highly salaried person with a large number of dependants may not have higher ability to pay taxes compared to a middle income salaried person having no or one or two dependants.
Consequently, the rate of direct taxes becomes—to some extent—arbitrary. The rate of taxes actually depends on the whims of the government. Further, tax and politics go hand in hand. A leftist’ government may impose a high rate of taxes while a ‘rightist’ government may levy a low rate of taxes.
As it is paid in lump-sum, it becomes inconvenient to the taxpayers particularly when they experience liquidity crises. Further, a taxpayer is supposed to provide various data relating to his income or wealth for the satisfaction of the tax-levying authority.
Because of complexities involved in the Indian Income Tax Act, taxpayers are virtually compelled to take the services of tax consultants. Thus, direct tax system is not only inconvenient but also expensive to the taxpayers.
It is unpopular since its burden is directly felt by the taxpayers.
(d) Possibility of Tax Evasion:
A direct tax is also liable to evasion specially when the rate of taxes becomes high or tax structure becomes unduly complicated. This system of taxation thus leads people to evade taxes. Tax evasion then leads to the emergence of a parallel economy of black income.
The immediate effect of black money is the accentuation of the degree of inequality in the distribution of income. Further, black income fuels inflation. Thus, ‘a direct tax creates civic consciousness’ is not true. A conscious citizen is not expected to evade taxes he can avoid tax in a legal way.
(e) Dampens Saving and Investment:
It discourages the initiative to work, saving and investment. High rate of taxes discourages people to work more since bulk of the income earned will have to be paid as taxes. A business firm may also hesitate in undertaking new ventures on the same ground. It also discourages ability as well as willingness to save and, hence, investment. Consequently, economic development may be hampered.
It is to be pointed out here that whether high rate of direct taxes reduce work effort or not is yet to be empirically established. Raising taxes increases work effort for some people while other people work less hard. Ultimately, it depends on the strength of income effect and substitution effect of tax rate increase, but high tax rate discourages savings leading to a shortage of capital—both domestic and foreign capital.