What is Difference Between Direct And Indirect Tax?

Accountancy Resources

What is Difference Between Direct And Indirect Tax?

Tax Author: Admin


The difference between a direct and indirect tax is complicated because it truly depends on whether you are asking from a “legal” or an “economic” perspective. In economics, a direct tax will refer to any levy that is both imposed and collected on a specific group of people or organizations. A sales tax, for instance, would not be considered a direct tax because the money is collected from merchants, not from the people who actually pay the tax (the consumers). An example of direct taxation would be income taxes that are collected from the people who actually earn their income. Indirect taxes are collected from someone or some organization other than the person or entity that would normally be responsible for the taxes.

In this economic context, the law may actually determine the person or entities from which the tax will be collected, but has nothing to do with how that tax burden is distributed in the market. Who bears the economic burden of the tax itself will be determined by market forces and can be calculated by comparing the price of the goods after the tax has been imposed with the price of the goods prior to the tax being in place.

For example, if the price of a gallon of gasoline was $2.50 without taxes and the government suddenly imposed a $0.40 tax, the economic forces of supply and demand would ultimately decide how this new burden is distributed between buyers and sellers. For instance, the price could increase to $2.75 per gallon after the tax, with buyers absorbing $0.25 of the increase and sellers the remaining $0.15. The law may have imposed the tax but the marketplace ultimately decided how it would be distributed.

In a legal sense, the meaning of direct and indirect taxes changes so that a direct tax, according to the U.S. Constitution, applies only to property and poll taxes. These direct taxes are based on simple ownership or existence. Indirect taxes are imposed upon a broad range of abstract ideas, including rights, privileges, and activities. In this sense, a tax on the sale of property would be considered an indirect tax while the tax actually owed on the property would be direct.

The legal distinction between direct and indirect taxes was important enough to warrant the passage of a Constitutional amendment – the 16th Amendment – in 1913. Prior to this amendment, the law was written in such a way that all direct taxes imposed by the government had to be directly apportioned to the population. In other words, any state having half as many people as another state would only have direct tax revenue that equaled half that of the larger state. The direct tax legal definition prevented the government from imposing personal income taxes prior to the passage of the 16th Amendment because of the apportionment requirement. The 16th Amendment ended the apportionment requirement and created personal income taxes. However, the apportionment requirement does remain on the books pertaining to other direct taxes, such as property taxes. Due to the fact that there is no federal property tax, this legal restriction has no literal meaning or fiscal impact.

To put this in perspective, an income tax is technically an indirect tax levied against people, corporations, and other legal entities recognized by the legal system. There are a number of systems in existence to help collect this income tax, from a simple flat tax to a more complex progressive system. This indirect tax on individuals is typically based upon total income minus legally permitted deductions. For corporations (for-profit corporations), the corporate income tax is based upon the net income or total revenue minus all expenses.

The 16th Amendment forever changed the tax code and paved the way for the passage of a wide assortment of indirect taxes that affect virtually every aspect of modern life. While it may seem like mere semantics when looking at the definitions of direct and indirect taxes, the fact is that government revenues increased greatly after the adoption of the 16th Amendment and the income taxes it helped to legalize.