Taxes are everywhere in our daily lives. Whether you’re buying a pack of chips or enjoying a trip to the cinema, cashing a paycheck, or selling investments, you pay taxes. The taxes you pay help fund important public services and amenities we all rely on. Broadly speaking, the Government of India levies two types of taxes – direct tax and indirect tax.
Within these categories, various types of taxes help collect revenue from different sources and transactions, such as income tax, GST, customs duty, and capital gains tax. Every Indian citizen should know about these taxes as they directly impact financial planning, compliance with the Income Tax Department, and overall economic participation. Let’s understand the difference between direct and indirect tax in detail, their various types, and how they benefit the economy.
Direct Tax vs Indirect Tax
Before we take a deep dive into direct tax vs indirect tax, here’s an overview:
| Direct Tax | Indirect Tax |
| Imposed directly on individuals, businesses, and other entities. | Paid when one buys goods and services. |
| Direct taxation follows a progressive system, where the tax rate increases as the taxpayer’s income or wealth increases. | Indirect tax is equal for all and is included in the price of goods and services. |
| Some examples of direct tax are income tax and capital gains tax. | Examples of indirect tax include GST and customs duty. |
| Direct taxes are governed by the Central Board of Direct Taxes (CBDT). | Indirect taxes are governed by the Central Board of Indirect Taxes and Customs (CBIC). |
| Direct tax cannot be transferred. If you earn the income or sell the assets, you must pay the tax yourself. | Indirect tax is transferable. When you buy goods and services the tax is included in the price you pay, which is paid to the government by the intermediary on your behalf. |
| Collection of direct tax by the government can be difficult. | It’s easier for the government to collect indirect taxes. |
| It’s possible to evade or avoid direct tax. | Indirect taxes are unavoidable as you pay them as part of the goods or services. |
| There may be an exemption on direct tax if the individual falls under certain income thresholds or meets specific criteria outlined in tax laws. For example, up to Rs. 1 lakh capital gains in a year are exempt from long-term capital gains tax. | Indirect tax is levied on the purchase of goods and services. For example, 18% GST on mobile phones. |
| It’s easier to notice when you pay tax directly because the payment is often big and happens all at once. | Indirect taxes are harder to notice, as they are embedded in the prices of goods and services you purchase. |
| To pay direct tax, you have to calculate your tax liability and file the tax returns. | You don’t have to file or calculate tax when paying indirectly, as the tax is already included in the price of goods and services. |
There are quite a few differences between direct tax and indirect tax, but they are both a major part of the government’s revenue and play crucial roles in funding government operations and public services.
What is Direct Tax? All You Should Know About It
Definition of Direct Tax
Direct taxes are paid directly to the government by the taxpayer and cannot be transferred to another party. This means that if you earn an income, make a profit, or sell assets you are responsible for paying the taxes yourself. An important aspect of direct tax meaning is that one isn’t obligated to pay these taxes if their income, profit, or gains fall below certain exemption limits set by the government. The Central Board of Direct Taxes (CBDT) is responsible for collecting direct taxes in India.
Types of Direct Tax
The government levies direct taxes in different forms such as:
- Income Tax: The most common type of direct tax is income tax, which is levied on individuals, Hindu Undivided Families (HUFs), businesses, and other entities on their income every year. Income in this case can have sources such as salary, business or profession, house property, investments, and other sources. Taxpayers calculate their taxable income and pay taxes directly to the government as per their slab.
- Corporate Tax: This tax is levied by the government on domestic and foreign companies registered in India. The corporate tax rate is different for different companies, and it depends on the company’s size, type, and what kind of business they do.
- Capital Gains Tax: When you sell an asset such as property, stocks, or mutual funds for a profit, a capital gains tax can be levied. The tax rate depends on how long the asset was held before selling and can be classified into short-term capital gains tax (STCG Tax) and long-term capital gains tax (LTCG Tax). Different assets have specific holding periods that define whether the gain is considered short-term or long-term, and thus there is not a fixed duration that can be considered short-term or long-term.
Examples of Direct Tax:
Some examples of direct taxes are:
- Income Tax: Paid by taxpayers based on their annual earnings from various sources.
- Corporate Tax: Paid by domestic or foreign companies registered in the country based on their profits.
- Property Tax: Individuals pay this tax to their municipalities every year on the value of their properties.
- Capital Gains Tax: Levied on profits made upon selling an asset.
- Wealth Tax: Levied on individuals, HUFs, and companies on their net wealth. However, this tax was abolished by the government in the financial year 2015-16.
Pros and Cons of Direct Tax:
Pros of direct tax:
- The income tax system in India is progressive, meaning that the taxpayers who earn higher incomes have to pay more taxes than taxpayers with lower incomes. The main purpose of this system is to make sure the tax burden is more equitable.
- They can help curb inflation.
- Direct taxes help the government develop infrastructure and fund welfare schemes so all citizens can benefit. They also form a major source of revenue for the government.
Cons of direct tax:
- Income tax can be a big burden on people as they are forced to make a large lump sum payment every year.
- Filing taxes can be a bit complex. To reduce taxable income, one has to maintain a thorough record of documents such as interest certificates, salary slips, and proof of investments to claim deductions.
- It’s harder for the government to enforce direct taxes. They are also harder to track for the government which leads to many cases of tax evasion and avoidance. Some taxpayers intentionally under-report their income and exploit loopholes to unethically and illegally save taxes. Ultimately, this leads to lower revenue for the government which harms the nation.
Impact on Economy:
Direct tax is a major source of revenue for the government, which plays a crucial role in funding public services and infrastructure like schools, roads, and hospitals. And since higher incomes pay more taxes than those with lower incomes, direct taxes also help reduce the wealth gap. Direct taxes also impact investments. To encourage individuals to invest more, the Income Tax Act of 1961 offers many tax deductions, exemptions, and benefits.
Investing in instruments such as Equity-Linked Savings Schemes (ELSS), Public Provident Funds (PPF), and Unit-Linked Insurance Plans (ULIP) can help reduce taxable income and overall tax liability. These investments not only help reduce your taxable income but also promote different aspects of financial planning. Also when you invest, you contribute to the economic growth of the country.
What is Indirect Tax? All You Should Know About It
Definition of Indirect Tax:
The government levies indirect taxes on the sale of goods and services. You don’t have to file these taxes yourself as they are already included in the price of the goods or services you purchase. The seller collects the tax and pays it to the government on your behalf. These taxes fall under the jurisdiction of the Central Board of Indirect Taxes and Customs (CBIC).
Take this example to understand the indirect tax meaning better. When you check the MRP of a product, you will notice that it says “inclusive of all taxes.” When you make the payment to the shopkeeper, you are paying for both the product and the tax on the product. Similarly, when you dine at a restaurant, the menu prices may or may not include taxes, but when you receive the bill, you’ll see a breakdown of the tax and the cost of the food. When you make the payment to the restaurant, the restaurant remits the tax portion to the government. In both these cases, you are paying taxes indirectly and transferring the tax burden to the intermediary who then pays it forward to the government.
Types of Indirect Tax:
In India, there used to be many types of indirect taxes such as sales tax, value-added tax (VAT), entertainment tax, luxury tax, and service tax. In 2017, however, the Goods and Services Tax (GST) was introduced, and many of these indirect taxes were subsumed under GST. Let’s take a look the the various types of indirect taxes:
- Goods and Services Tax (GST) – GST is the most common type of indirect tax. GST aimed to simplify the indirect tax system by replacing the many indirect taxes levied by the central and state governments. There are four different kinds of GST –
- Central Goods and Services Tax (CGST)
- State Goods and Services Tax (SGST)
- Integrated Goods and Services Tax (IGST) and
- Union Territory Goods and Services Tax (UGST)
There are 4 GST rates – 5%, 12%, 18%, and 28%, which are applied based on the type of goods or services. Some goods and services such as milk are also exempt from GST.
- Customs Duty – This type of indirect tax is levied on the goods and services you purchase from abroad. The tax rate depends on the type of product or service and where the goods are being imported from.
Examples of Indirect Tax:
Here are some examples of indirect tax:
- GST: Most of the goods and services sold in India include the Goods and Service Tax. GST is paid to the seller when you purchase any goods or services, who then pays the tax to the government.
- Excise Duty: This is the tax levied on manufacturers of certain goods such as alcohol and tobacco.
- Customs Duty: The tax paid on imported goods and services.
- Value-Added Tax (VAT): This tax is added to goods and services from each stage of production to distribution. VAT was subsumed under the GST.
- Service Tax: Service tax was charged by service providers such as bankers. It is also now a part of GST.
Pros and Cons of Indirect Tax:
Pros of indirect tax:
- Every citizen buying goods or services pays tax and contributes to the country’s economic growth.
- More people pay indirect taxes, and they are also easier to collect than direct taxes.
- Taxes are transferable, so you don’t have to file them yourself. You simply pay the tax-inclusive price of the goods or services to the seller, who is responsible for paying the taxes to the government on your behalf.
- Indirect taxes cannot be dodged or avoided, unlike direct taxes.
Cons of indirect tax:
- Since indirect taxes are regressive, all citizens pay equal taxes. This disproportionately affects individuals with lower incomes.
- Indirect taxes raise the overall cost of goods and services, which makes the product more expensive and can even lead to inflationary pressures.
- Taxpayers are rarely aware of the amount of tax they pay indirectly since it is included in the total cost.
Economic Implications:
Indirect taxes can significantly increase the price of goods and services, which ultimately leads to reduced consumer purchasing power. For example, there are different GST rates for different types of products. No GST on fresh milk, 5% GST on edible oil, 12% GST on dried nuts, 18% GST on mobile phones, and 28% GST on air conditioners. A tax advisor can help navigate these varying tax rates and optimise financial planning. With these varying tax rates, the government can also control how consumers behave. This can be beneficial as higher indirect tax rates on harmful items like alcohol can encourage a healthier lifestyle.
The Benefits of Direct Tax and Indirect Tax
Benefits of Direct Taxes
- Direct taxation in India is progressive, meaning that the tax rate increases as the taxpayer’s income or wealth increases. Those who have high incomes fall under a different tax slab than those with modest incomes. The benefit of a progressive taxation system is that it promotes fair distribution of the tax burden and makes sure that people with more financial resources contribute more to the government’s revenue.
- This also helps reduce income inequality. The taxes paid by wealthier individuals are higher, which can then be used to fund public infrastructure and services, welfare schemes, and other developmental programs that benefit the entire population. It is an effective way to redistribute wealth.
- When the inflation rate is too high, the government increases the tax rates as a way to control inflation and stabilise the economy. When taxes are raised, consumer spending and aggregate demand fall, which can help in controlling inflationary pressures.
Benefits of Indirect Taxes
- Indirect taxes are much easier to collect as they are already included in the prices of goods and services, which are paid by consumers at the point of purchase.
- Unlike direct taxes, indirect taxes do not need taxpayers to file returns, which makes them easier for both the government to enforce and taxpayers to comply with.
- Also unlike direct taxes, indirect taxes are equal. The indirect tax paid by an individual doesn’t depend upon the individual’s annual income. Even those within the income tax exemption limit pay indirect taxes when they buy goods or services.
- One cannot avoid indirect taxes like one can avoid direct taxes. The scope of tax evasion in the case of indirect taxes is extremely limited.
- The government can use indirect taxes to control the consumption of certain goods and services by simply adjusting the tax rates. For example, the government can levy higher taxes on goods that are considered harmful such as alcohol and tobacco, or on luxury items like high-end electronics. They can also lower the tax rates on essential items to make them more affordable for consumers.
Also Read: Benefits of Tax Planning in 2024
FAQs on Direct And Indirect Tax:
How should I know which tax is direct or indirect?
Indirect taxes are paid when you buy goods and services, for example, GST and customs duty. These taxes are collected on your behalf by intermediaries, who then pay them to the government. You won’t need to file for indirect tax. Direct taxes on the other hand are paid directly to the government by you, for example, income tax and capital gains tax. You have to file a tax return to pay these.
Which is better, direct or indirect tax?
Both types of taxes are different with their advantages and disadvantages. They work differently and impact us and the economy differently. Thus, it cannot be said that one is better than the other. Direct taxes are more equitable as they are based on the taxpayer’s ability to pay, but they are easier to evade which can harm the country. On the other hand, indirect taxes are unavoidable, as you pay them when you purchase goods and services.
Is GST a direct or indirect tax?
GST is an indirect tax. GST stands for Goods and Service Tax, and it is included in the price of goods and services. You pay the tax to the seller or service provider when you make a purchase, who then pays the tax to the government on your behalf.
Does Goods and Service Tax (GST) fall under the direct or indirect tax category?
The Goods and Service Tax falls under the indirect tax category.
Who governs and administers direct and indirect tax in India?
In India, the governance of direct taxes is done by the Central Board of Direct Taxes (CBDT), and the Central Board of Indirect Taxes and Customs (CBIC) governs indirect taxes.
