Understanding Direct Tax and Indirect Tax: What You Need to Know

February 21, 2024
direct tax and indirect tax

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The government earns money mainly from direct tax and indirect tax. The other sources include interests, dividends, as well as profit shares collected from public sector companies. 

Direct tax is levied on income and profits earned by individuals, HUFs, and companies. It includes money collected by way of income tax, personal property tax, real property tax, and tax on assets. On the other hand, indirect taxes are imposed on the goods and services that you buy. 

GST, TDS (Tax Deducted at Source), and Customs duty come under indirect taxes. 

As per reports, the gross collections earned by the government via direct taxes alone, for the year 2022-2023 (up to January 10, 2023) is INR 14.71 lakh crores.  

What are Direct Tax and Indirect Tax?  

As an Indian citizen, you are obliged to pay tax to the government either from whatever you are earning or through the goods and services that you purchase. It is a mandatory recurring fee that you have to pay to the state as well as the central government.  

On a broad level, there are two main categories of taxes – direct tax and indirect tax. Here is some information that will help you distinguish between direct tax and indirect tax: 

Direct Tax 

Direct tax is a tax that you pay directly to the authority that is imposing the tax. As an individual, HUF, or business entity, you have to pay this on your own accord. The burden of tax cannot be shifted to any other entity.  

The CBDT (Central Board of Direct Taxes) is responsible for collecting and administrating direct taxes in India. Governed by the Department of Revenue, the CBDT provides regular inputs to the government to plan direct taxes and create policies around them. 

Direct tax is levied as a percentage of the income or profit you have earned. So the higher the income you earn, the higher will be the tax you have to pay. Any Indian under the age of 60 years, who earns more than Rs. 2.5 lakhs per year will have to pay Income tax. 

Indirect Tax 

An indirect tax is a tax that is levied on goods and services that are purchased by consumers. It will be included in the price of the product that you buy. Although it is the consumer from whom the tax money is collected, the person paying the tax would be the one who is selling the product (manufacturer or supplier).  

The CBIC or Central Board of Indirect Taxes and Customs is the authority in charge of collecting and administrating indirect tax. As part of the Department of Revenue, the CBIC formulates policies concerning indirect taxes and takes steps to prevent smuggling and evasion of duties.  

The indirect taxes in India have to be paid by everyone irrespective of the income that they earn.  

Types of Direct Tax and Indirect Tax 

Direct tax and Indirect tax are the two main sources of revenue for the Indian Government. The process of calculation and collection is different in both cases. Here are a few examples of direct and indirect taxes

Example of Direct Tax 

Here are a few examples of direct tax that can help you get clarity on the direct tax meaning: 

Income Tax 

  •  One good direct tax example is the income tax that you file every year. It is calculated as a percentage of your salary, depending on how much you earn. The good thing is that you can lower your tax liabilities through some credits and deductions. 

Transfer Tax 

  • One example of the transfer tax is estate tax which is levied on the properties of deceased individuals, including financial accounts and trusts. Another example is gift tax where the person transferring the property has to pay a certain amount as tax. 

Property Tax 

  • This is the tax that is charged on lands and buildings that are used to maintain public services such as schools, libraries, roads, police, and fire departments. 

Entitlement Tax 

  • This is the tax that gets deducted from your payroll every month to make you a part of social programs such as Social Security, Medicare, and Medicaid. All these deductions are grouped under the Federal Insurance Contributions Act. 

Capital Gains Tax 

  • This is the tax that you pay when you sell your assets such as real estate, stocks, or even your business. It is a part of the profit that you earn by selling your property. 

Also Read: How to Become Income Tax Officer in India

Example of Indirect Tax 

A few examples of today’s indirect taxes in India include: 

GST or Goods & Services Tax 

  • Since the 1st of July 2017, India has implemented the GST slab system with different rates of GST for different commodities. Any product that you buy will attract GST as per its slab rate. Every business that has an annual turnover of more than Rs. 20 lakhs, has to pay GST. 

Customs Duty Tax 

  • This is the tax that you pay when you transport goods out of the country. It needs to be paid by every entity that is involved in international trading. 

Excise Duty 

  • Although this tax has been replaced by GST, certain commodities still attract excise duty at a time when they are being removed from the warehouse. These include fuel, petroleum, and liquor.  
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Benefits of Direct and Indirect Taxes 

Direct and indirect taxes have their own sets of benefits. Being aware of these will help you understand the difference between direct and indirect tax.  

Key Benefits of Direct Tax 

Although every individual, HUF, or company with an annual income of more than Rs. 2.5 lakhs have to pay direct tax, and there are still certain advantages of paying this tax.  

  • It promotes equality: Direct taxes are charged differently for different people, based on their annual income. The main purpose of collecting direct taxes is to promote equality among the citizens and payers. 
  • It increases the revenue of the government directly: Since direct tax is paid directly by the taxpayers to the government, it adds up directly to the revenue of the government.  
  • It helps in curbing inflation: The amount of direct taxes collected by the government fluctuates every year, depending upon the earnings of the taxpayers. This helps in keeping inflation under control.  
  • It is convenient to collect: In most cases, the employers deduct the taxable portion of the salaries of their employees, before transferring them. This makes it very convenient to collect taxes as the employers act as tax collectors. 

Key Benefits of Indirect Tax 

Like direct taxes, Indirect taxes also offer several key benefits to the government as well as the taxpayers. A few such benefits are listed below: 

  • Transferrable Liability: Unlike direct taxes, the liability of indirect taxes can be transferred to other entities at a later date. Therefore, the actual tax burden falls on the person consuming the goods and services. Also, since indirect taxes can be collected directly, it saves a lot of time and effort for the government. 
  • Easy Collection: When compared to direct taxes, indirect taxes are easy to collect. They get collected automatically when products are purchased or transported. The authorities won’t have to put any effort to collect these taxes. 
  • Wider Base of Taxpayers: People with an annual income lower than Rs. 2.5 lakhs need not pay income tax. Also, those who fall in the income bracket of Rs. 2.5 lakhs to Rs. 5 lakhs per annum get Rs.12,500 tax rebate as per Section 87A. When compared to this, indirect taxes have no such exemptions or rebates. Everyone who purchases products or services will have to pay GST, irrespective of how much they earn.  
  • Equitable Contributions: The amount of indirect tax you need to pay depends on the cost of products and services you purchase. So if your consumption is less you pay less tax and vice versa. Also, the tax rate on luxury items is higher, which makes tax contributions equitable. 

Also Read: Understanding the Salary Slip

Comparison Between Direct And Indirect Taxes 

Direct Tax and Indirect Tax are the two main types of taxes collected by the Indian government to increase its revenue. While direct taxes are paid directly by the taxpayer to the government, indirect taxes would be collected by intermediaries who transfer their tax liabilities to their end consumers.  

For instance, income from the business is a part of direct tax. Whereas under indirect tax the prices of the goods are taxed. Here are a few points that will help you distinguish between direct and indirect taxes

  • Taxpayers: Direct taxes have to be paid by individuals, HUFs, and companies whose annual income is more than Rs. 2.5 lakhs. In the case of indirect taxes, the taxpayers would be the end consumers who purchase and consume products and services. However, the collection and payment of such taxes will be done by manufacturers and retailers who sell these products and services. 
  • Tax Applicability: Direct tax applies only to the individual, HUF, or company that is paying that tax. Indirect tax, on the other hand, will be levied on every stage of production and distribution of the goods until they are consumed by the end consumers.  
  • Transferability of the Tax Liability: The tax liability in case of direct taxes cannot be transferred to any other entity. The taxpayer will have to pay it on his own accord. Nevertheless, the tax liability in the case of indirect taxes is generally transferred by the manufacturer/supplier to the end consumers who consume their goods. 
  • Tax Evasion: Although direct tax cannot be transferred, it can be evaded if you invest in certain tax-saving instruments. Indirect tax, on the other hand, cannot be evaded at any cost. 

Key Differences Between Direct and Indirect Taxes

AspectDirect TaxesIndirect Taxes
MeaningTaxes paid directly by individuals, or companies to the government.Taxes imposed on goods and services purchased by consumers, collected indirectly from people.
AuthorityCentral Board of Direct Taxes (CBDT).Central Board of Indirect Taxes and Customers (CBIC).
TaxpayersIndividuals and companies with taxable income.Consumers who purchase goods and services.
Tax ApplicabilityDirectly applied to the income or profits earned by taxpayers.Applied at every stage of production and distribution until consumed by consumers.
TransferabilityTaxpayers pay directly.Through pricing of goods and services.
ExamplesIncome tax, Property tax, Entitlement tax.Goods and Services Tax, Customs duty tax and Excise duty.
Ease of CollectionCollection process can be complex as it requires direct assessment and payment by taxpayers.Easier to collect as it’s automatically imposed on goods and services at the point of purchase.
Tax EvasionCan be evaded through tax-saving instruments.Difficult to evade as taxes are embedded in the prices of goods and services.

Take Aways 

Direct tax and indirect tax are both very important to the government as they form as they help in building the economy of the country. Understanding the difference between direct and indirect tax will offer clarity on the purpose and benefits of each of these types. If you are a tax expert and would like to share your knowledge with others, here is a wonderful opportunity for you to earn some money. Become a Chegg Q&A Expert and connect with students across the world.  

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Frequently Asked Questions

How should I know which tax is direct or indirect?  

  If a tax is paid directly by the taxpayer to the government, it is a direct tax. If there is an intermediary to collect tax and then pay it to the government, it is an indirect tax. 

What are the different types of indirect taxes?

The different types of indirect taxes include GST, customs duty, and excise duty. The inception of GST has consumed various other taxes such as service tax, value-added tax, entertainment tax, luxury tax, and a portion of excise duty. 

What are the different types of direct taxes? 

The different types of direct taxes include income tax, property tax, entitlement tax, capital gains tax, and transfer taxes such as gift tax and estate tax. 

Is the rate of payment different for direct and indirect taxes? 

 Yes, the rate of payment is different for direct and indirect taxes. For direct taxes, the rate of payment depends on the income that you are earning every year. In the case of indirect taxes, the rate depends on the slab of GST, the product falls in.  

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