Taxes are classified as direct tax and indirect tax. But the meaning of these two types of taxes is not clear. For a long time economists interpreted these two types in different ways. For instance, one group of economists considered taxes on production as direct taxes and those on consumption as indirect taxes. J.S. Mill distinguished these two types of taxes in terms of the ability to shift the tax. Any person on whom the tax is imposed, if he himself pays the tax, it is called direct tax and if he is able to shift the tax to somebody who ultimately pays it then it is called indirect tax. For example, income tax is paid by a person as it is levied on the income earned by him, so it is a direct tax. On the other hand the sales tax imposed on the seller is shifted to the buyer. Now-a-days the distinction between direct and indirect taxes is explained with reference to the basis of assessments and not on the point of assessment. Hence, taxes assessed on the basis of income are called direct taxes and those assessed on the basis of expenditure are called indirect taxes. However, even this classification is not free from difficulties. For instance, when one man’s income is treated as another man’s expenditure, tax on one man’s income may become the tax on another man’s expenditure. Hence, till date there has been no satisfactory distinction between direct and indirect taxes. However, in practice this distinction is retained more for the purpose of grouping the different taxes.
Merits of Direct Tax
- Direct taxes are based on the principle of ability to pay and so they help to distribute tax burden equally.
- As the tax is imposed on each individual, for example, based on his income, he is certain about the amount of tax payable by him. Hence, the direct tax satisfies the canon of certainty.
- Direct taxes are also highly flexible. The revenue from them can be increased or decreased depending upon the need of the government. For example, the government can simply raise the rate of tax to get more revenue and bring down the tax rate to reduce the revenue.
- The tax paying people are more interested in the ways in which the tax revenue is spent by the government. They feel proud of participating in the public projects by paying tax.
Demerits of Direct Tax
- Direct taxes like income tax, are considered as tax on honesty of the people. Those people who can evade or avoid it are rarely prosecuted. Hence, there is no incentive to pay the tax.
- There is no logical basis for levying or determining the tax. As a result political considerations over-weigh the economic and other considerations. For example, a communist government may impose very stiff tax rate while a socialist government may not do so. Hence, there is ample scope for arbitrariness in the imposition of tax.
- From the view point of tax collection, the cost of collection of direct taxes is very high compared to that of indirect taxes, For example, income tax has to be collected from every person who should pay tax. Hence, a very elaborate arrangement is required in the form of administrative machinery which simply increases the cost of tax collection.
- One more difficulty is not all the tax paying individuals are aware of the provisions of income tax. The provisions are so complicated that unless an individual is clear about them he will be paying more tax. In the case of corporate tax, every effort is made to minimize the tax burden by taking advantage of the loopholes in the tax laws.
- Another demerit of the direct taxes is that in case of any dispute, it takes a long time for the common public to secure justice and still more time to get back the excess tax paid.
The evaluation of the merits and demerits of direct taxes indicates the problems experienced are more related to administrative aspect and not the economic aspect. Efforts have been taken in India to simplify the assessment, exemptions, procedures and refund of direct taxes. This has helped to increase tax revenue from direct taxes. The tax administrators in India adopt persuasive techniques instead of coercive methods to obtain as much tax revenue as possible and minimize tax evasion and avoidance. Frequently amnesty schemes are announced to provide opportunities to the public to turn honest.
Merits of Indirect Tax
- Indirect taxes are imposed at the point of consumption and so it is very easy to collect them.
- The cost of collection of indirect taxes is almost nil as every person will pay the tax as he buys the commodity on which the tax is imposed.
- It is very simple and easily understandable as only a fixed percentage of the sale price is collected as tax.
- A significant merit of indirect taxes is that it cannot be evaded or avoided as the only alternative to not paying the taxes is not to consume.
- Like direct taxes, indirect taxes are also highly flexible. They can be altered to suit the requirement of governments need for funds.
- Another important merit is that even the poorest in a country will contribute towards the cost of public service.
- Indirect tax is the ideal way to discourage consumption of luxurious and unwanted goods.
Demerits of Indirect Tax
- The fundamental defect of this type of tax is that it does not conform to the principle of ability to pay as it affects every individual hi the same way irrespective of his economic position.
- The revenue from indirect taxes cannot be certain. This is because a tax imposed on a commodity with highly elastic demand will bring down the demand for the commodity and along with that the taxes. On the other hand a tax on a good with inelastic demand can fetch the desired revenue. A main difficulty is that the elasticity of good is influenced by several factors and so the tax revenue may be uncertain.
- As the indirect taxes are usually a fraction of the price paid, the tax payers never feel the payment of taxes. Hence, they evince little interest to know how the amount of tax revenue is spent.
- Yet another problem of indirect taxes is that very stiff rates encourage black marketing, smuggling and other illegal trading practices.
- Sometimes, the indirect tax levied on a commodity will vary from state to state causing lot of hardship for the tax administrators and encouraging the people to buy the goods in the state where the tax is less and sell the goods, in the state where the tax is high. This might affect the businessmen in the latter state.
- Though the cost of collection of indirect taxes is less, yet, the records to be maintained and inspected are voluminous involving enormous time and energy of the lax administrators. This gives wide scope for corruption and malpractice among the officials.
Comparison of Direct and Indirect Taxes
Having discussed the merits and demerits of both the direct and indirect taxes, it could be understood that indirect taxes are superior to direct taxes in several respects. For example, indirect taxes can be selectively imposed on goods of harmful nature to discourage the consumption of such goods. This selectivity is not possible under direct tax. Between the two types of taxes, direct taxes directly affect the incentive to work and save severely. But indirect taxes have no such direct impact. In a developing country, to reduce income inequality increased dose of indirect taxes is better. Though this may mean taxing the poor also, yet in modern times, with overall improvement in standard of living, slowly poor people should also be subject to the tax net. Moreover, in a country where there is large scale tax evasion, tax avoidance, black marketing, smuggling, etc., indirect taxes are the best instruments to put down such evil practices. All these superiority of indirect taxes over the direct taxes need not mean that direct taxes should be abolished. A balance should be maintained between these two types of taxes so as to discourage and avoid any attempt to evade or avoid tax. The various problems associated with each one of these two types of taxes should be seriously studied to overcome them. Especially the administrative problems can be overcome only by exposing the officials to the modem techniques of tax collection, giving them attractive incentives and rewards for honest work, encouraging them to suggest modification to improve the effectiveness of the taxes, etc.