Page 12 - DCOM308_DCOM502_INDIRECT_TAX_LAWS

Unit 1: Introduction to Indirect Taxes

To put this in perspective, an income tax is technically an indirect tax levied against people, Notes
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.

1. Allocation Effect: The allocative effects of direct taxes
are superior to those of indirect taxes. When a
particular amount is raised through a direct tax like
income tax, it would imply a lesser burden than the
same amount raised through an indirect tax like
excise duty.
An indirect tax involves excessive burden as it distorts
the consumer’s preference regarding goods due to
price changes. Thus an indirect tax has an adverse
effect on the allocation of resources than a direct tax. Image Credits © Curious Spider
2. Distributive Effect: Direct taxes are progressive and they help to reduce inequalities. But
indirect taxes are regressive and they widen the gap of inequalities.
Hence, direct taxes are regarded to be superior to indirect taxes in effecting a more equitable
distribution of income and wealth. But this is not always true.
Even indirect taxes can be made progressive by levying them on luxuries and exempting
them on necessaries.
Both direct and indirect taxes are alternative methods of achieving any particular
redistribution of income.

3. Administrative Costs: The administrative costs of direct taxes are more than that of indirect
taxes. Direct taxes are narrow based and has many exemptions. Indirect taxes can be
conveniently collected and cost of collection is constant overtime. Indirect taxes are easier
to administer than direct taxes.

From point of view of efficiency and productivity, indirect taxes are better. Indirect taxes
are wrapped up in prices and hence they cannot be easily evaded. They are more productive
as their cost of collection is the least.
Thus, from point of view of administrative costs, indirect taxes are relatively superior.
4. Built-in Flexibility and Stability: Direct taxes are more flexible than indirect taxes. During
a period of prosperity, direct taxes fetch more revenue as they are progressive. But indirect
taxes are proportional and they do not fetch as much revenue as direct taxes.

Direct taxes help to reduce the inflationary pressure by taking away the excess purchasing
power and hence they promote stability. But indirect taxes are inflationary.

Hence, from the point of stability, direct taxes are preferred to indirect taxes.

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