Economics Discussion

Direct and Indirect

Tax: Merits and
Demerits | Economics
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In this article we will discuss the merits and

demerits of direct and indirect taxes on an
economy.

Taxes may be classified as direct and

indirect. Direct taxes are levied on a
persons or a firms income or wealth and
indirect taxes on spending on goods and
services. Thus, direct taxes are paid directly
by the person or firm on whom the
assessment is made, while indirect taxes are
paid indirectly by consumers in the form of
higher prices. Direct taxes cannot be legally
evaded but in direct taxes can be avoided
because people can reduce their purchases
of the taxed goods and services.

Direct Taxes:
Examples of direct taxation include income
tax, corpora
tion tax (on companies profits),
capital gains tax (a tax on the profits of sales
of certain assets), wealth tax (which is a tax
on ownership of property or wealth) and a
capital transfer tax (a tax on gifts to replace
death duties). Direct taxes are mainly
collected by the central government.

Advantages:
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(i) It is easy to determine the incidence of

the tax a person or institution who actually
pays and suffers the burden of tax.

(ii) Direct taxes tend to be progressive

people in the higher income group pay a
greater percentage than poorer people, e.g.,
income tax is graduated so that high income
earners pay a larger percentage; also a
selective wealth tax would only apply to
those owning more than a certain level of
wealth.

(iii) Direct taxes are easy to collect. Consider,

for example, the PAYE system which is used
to collect income tax from most wage and
salary earners.

(iv) Direct taxes are important to the

governments economic policy. If the
government is fighting inflation it can
impose, for example, high levels of income
tax to restrict consumer demand. If the
government is concerned about
unemployment it can reduce the levels of
income tax to increase consumer demand
and increase production.

Disadvantages:
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(i) Direct taxation may be a disincentive to

hard work. High rates of income tax, for
example, may discourage people from
working overtime or trying to gain
promotion at work. Some economists blame
the brain drain (i.e., the emigration of
highly qualified persons, such as scientists
and doctors) on Indias high levels of
taxation.

(ii) Direct taxation discourage savings

because, after paying tax, indi
viduals and
companies have less income available to
save. This means that investment, which
relies on the level of savings, is low and this
could cause less production and
employment.

(iii) This type of taxation encourages tax

evasion to avoid paying so much tax.
(iv) There is no element of choice about
paying the tax it is unavoidable.

Indirect taxes:
Examples of indirect taxation include
customs duties, motor vehicles tax, excise
duty, octroi and sales tax. Indirect taxes are
collected both by the central and state
governments but mainly by the central
government.

Advantages:

(i) Indirect tax is fairly easy to collect.

(ii) It is easy to determine the incidence of

an indirect tax.

(iii) The government can use it to discourage

certain types of consump
tion. A high rate of
tax on tobacco can, for example, affect
smoking habits.

(iv) Indirect taxation is a good way of raising

revenue when levied on goods with an
inelastic demand, such as necessities.

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(v) Tourists do not pay income tax. But they

spend money on goods and services. This
adds to the tax revenue of the government.

(vi) Consumers have a choice as to whether

they pay the tax. They can avoid paying the
tax by not consuming the goods which are
being taxed.
(vii) Indirect taxes do not have a discentive
effect on work.

Disadvantages:

(i) Indirect taxes are regressive. A regressive

tax is one which causes a poor person to pay
a higher percentage of his or her income as
tax than a rich person. For instance, the tax
ingredient of the price of a new television
set would be the same for the poor and the
rich person, but as a percentage of the poor
persons income, it is far greater.

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(ii) These taxes are not impartial. In recent

years, certain groups of consumers have
complained that they are being heavily
penalised by taxation, e.g., drinkers,
smokers and drivers.

(iii) Indirect taxes may contribute to

inflation. The imposition of an indirect tax
on an item like petrol will increase its price.
Since petrol is an essential input in a large
number of industries, this may set off an
inflationary spiral. Moreover, trade unions
demand higher wages to maintain the real
incomes of workers.
The advantages and disadvantages of two
types are listed in Table 4.

Conclusion:

So, the conclusion is that, in a good tax

system there should be a proper balance
between direct and indirect taxes. The
revenue will be optimum and loss of
incentives minimum.
Home Direct and Indirect Tax Economics Taxation

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