Tax: Direct or Indirect?

Whenever union budget is presented, there is always a clamour for reduction in slab rates or concessions in exemptions of income tax. But is it really justified? Is it a better idea for the government to reduce the share of income tax in its overall revenue?

Income tax is a direct tax that is levied on the income or profits of the person who pays it, e.g. corporate tax, property tax, wealth tax and gift tax.

Indirect tax, on the other hand, is charged on goods and services, and is generally imposed on suppliers or manufacturers who pass it on to the final consumers or buyers. GST, customs duty, excise duty are example of indirect taxes.

The first and foremost principle of taxation is fairness, which has two types – vertical and horizontal. Vertical fairness means that the rich should bear a high burden than the poor both in relative and absolute terms. This is largely followed by our taxation policy on income, but often at the cost of what is called horizontal fairness.

Horizontal fairness demands that if income of two persons is the same, their tax liability should also be the same, but it rarely happens. For example, a man earns Rs five million from agriculture, and the same income is earned by two other persons from salary and business respectively, the tax burden for all the three will be different. This anomaly needs to be addressed.

The higher share of direct taxes in total revenue shows the progressive nature of taxation policy. It envisages higher tax payment by rich individuals. The multiple slabs with increasing marginal rates show further maturity of the system.

On the other hand, indirect taxation is regressive in nature, as tax is applied on the price paid for purchasing goods or services, and not on the income of the buyer. So the tax paid on a packet of match-box or on a LED bulb remains the same for both rich and poor individuals, but it will pinch a poor person more, who has less income.

To reduce the impact of generalisation, multiple rates are prescribed for essential and luxury items, but this classification, howsoever applied, will not be satisfactory. Moreover, indirect taxes may enhance inflation, contrary to direct taxes.

Indirect taxes are more efficient, no doubt. These are not as inconvenient and burdensome as direct taxes, because the taxpayer feels the pinch only when he buys the goods. But its impact is far-reaching. An increase in the cost of petrol has the snowballing effect on prices of other products as well.

Though the share of indirect taxes has been brought down from 81% to around 55% during the last three decades, it still cannot be treated as healthy. Lack of proper administration in collection of direct taxes, barring salaries and perquisites, makes tax evasion possible.

The need of the hour is to increase the share of direct taxes, not only from salaries, but also from wealth, inheritance, businesses, agriculture, and of course, capital gains. A higher share of direct taxes will help us achieve the national objectives of growth with equality.

But there is an urgent need for devising a foolproof system to calculate such taxes in a fair and equitable manner by plugging all the loopholes in the tax law.

Taxation is an important tool for social upliftment and economic development. A tax shouldn’t be considered as fine, but yes, the hard-earned tax revenue shouldn’t be splurged as freebies, as politicians are doing now-a-days for winning elections.

–Kaushal Kishore

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