Direct Tax vs. Indirect Tax: Understanding the Key Differences

A direct tax refers to the amount that the government charges on personal or corporate income. If you’re earning money, whether as an employee, freelancer, business owner, investor, etc. you are required to pay a portion of the income to the government as tax. Common types of direct taxes in India include:

• Income Tax: Paid by individuals on salary, business profits, or any other types of income.
• Corporate Tax: Paid by companies to the government based on their business profits.
• Capital Gains Tax: Paid on profits from selling capital assets such as property, shares, mutual fund units, etc.

In the case of direct taxes, the individual/business that is earning or making a profit is responsible for paying the tax directly to the government tax authorities. Hence, the burden of a direct tax cannot be passed on to another entity.

An indirect tax is a type of tax that is typically applied on the consumption of goods and/or services. Unlike direct taxes which are typically applied to income and/or profits, you pay indirect tax when you buy any goods or services. However, this tax is paid to a third-party such as a service provider or retailer, who is required to pay the due tax to appropriate tax authorities. Common examples of indirect tax include:

• GST (Goods and Services Tax): Charged on a wide range of products and services in India.
• VAT (Value Added Tax): Currently applicable to a limited number of goods in India such as alcohol for human consumption, petrol and diesel.
• Capital Gains Tax: Levied on imports to manage trade and keep local industries safe.

In the case of an indirect tax, the consumer/end-user, pays the tax, even though the indirect tax payment to the government is routed through the seller or service provider.

When you distinguish between direct and indirect tax, you realise each type targets different financial activities. Direct tax focuses on earnings/profits, while indirect tax focuses on spending. For someone looking to reduce direct tax outgo, it might mean optimising your direct tax liabilities through tax-saving investments. However, a decrease in spending and consumption can help in reducing the impact of indirect taxes on your budget.

The table below shows the difference between direct and indirect tax.

Below is a short list of the types of direct taxes and indirect taxes applicable in India under different scenarios:

The above table is a simplified summary to illustrate applicability of direct and indirect taxes in India. Real-world taxation situations are typically more detailed and may often involve additional charges like surcharge, cess, while also featuring different compliance rules in different states. Still, the main takeaway is that direct tax relates to your earnings or profits, whereas indirect tax attaches itself to the consumption of goods and services.

Direct tax such as income tax is progressive in nature and directly reduces your take-home pay. If you have a higher salary, you will come under a higher tax bracket, which means a larger portion of your income will be payable in direct taxes. But you do have relief in the form of deductions under sections like 80C or 80D of the Income Tax Act, provided you have opted for the old tax regime.

Indirect taxes influence your monthly expenses as they are added to the price of goods and services you purchase. Whenever you buy something, be it groceries, petrol, or a mobile phone, you pay indirect tax such as GST or VAT as part of the final cost. Higher GST rates on specific items can increase their price. The rate of indirect tax is not impacted by the income of the individual making the purchase.

You can focus on direct tax for savings using these common strategies:

• Life insurance premium payment (Section 80C- deduction up to Rs. 1.5 lakhs per year).
• Public Provident Fund (PPF), National Pension System, Retirement Plans or ELSS for tax deduction u/s 80C.
• Health insurance premiums (Section 80D).

Do note that the above-mentioned tax deduction benefits can only be availed if one has opted for the old tax regime.

With indirect tax, you don’t have as many direct routes for personal savings, but businesses can receive some relief through input tax credit under GST, reducing the effective tax burden. For individual consumers, choosing products taxed at lower GST slabs or shopping during a sale can help save money on purchases but this can only provide a limited relief with respect to the indirect tax payable.

The Central Board of Direct Taxes (CBDT) collects and manages direct taxes, like income tax, corporate tax, and capital gains tax. It oversees how income tax is collected from individuals and how corporate tax is gathered from businesses. The government uses the funds collected via taxes to fund infrastructure development, defence expenditures, provide public services, and contribute to the overall economic progress of the country.

In India, direct tax is currently collected in the following ways:

• TDS (Tax Deducted at Source) – TDS is deducted by employers, banks, and other entities on income like salary, interest on bank deposits, and rent before payment is made to the tax authorities.
• Self-assessment tax – Individuals pay this directly by estimating their tax liability during the applicable fiscal.
• Advance tax – Paid quarterly on non-salary income (e.g., business profits, income from profession, etc.) in four instalments by self-employed individuals and businesses.

Both direct tax and indirect taxes are integral parts of the tax system in India. Each of these systems have their own benefits and limitations as discussed below:

• Pros of Direct Tax: The biggest plus point is its progressive nature. People who earn more pay taxes at a higher rate, helping in reducing income inequality. Also, there are various tax saving investments and expenses available that can help eligible taxpayers reduce their tax outgo.
• Cons of Direct Tax: Compliance can be difficult for the ones not familiar with tax rules. If rates rise, some believe it discourages people and businesses from increasing spending/investing in growth, potentially slowing economic growth.
• Pros of Indirect Tax: Collection is simpler since tax is added to the price of goods or services. Everyone contributes, including people in the informal sector. It also encourages savings by taxing how much you spend rather than what you earn.
• Cons of Indirect Tax: Since indirect taxes apply evenly to all consumers, they can unevenly impact lower-income households, as a greater part of their earnings goes toward essential goods and services. It makes everyday essentials relatively more expensive for lower income in comparison to higher earners. Plus, consumers can’t directly claim tax rebates, except if the consumer is a business who can avail input tax credit.

When trying to differentiate between direct tax and indirect tax, one needs to look at who is ultimately responsible for paying. If the cost comes directly out of someone’s income or profits, then it’s a direct tax. If the tax is embedded in the price of a product or service, that’s an indirect tax.

Another way to distinguish between direct and indirect tax is by checking if the tax burden can be transferred. In direct taxes, you the responsibility of tax payments cannot be transferred, only the earner can pay their own income tax. In indirect taxes, businesses pay the tax to the authorities but pass it on to the customer through higher prices.

Staying mindful of these differences helps you keep track of why your salary slips display TDS (a direct deduction) and why the maximum retail price of a bar of soap includes GST (an indirect charge).

It is important to know the difference between direct tax and indirect tax as far as proper management of finance is concerned. The two taxes are essential for governments as this tax revenue can be used for various purposes such as building roads, financing schools and healthcare and much more.

Knowing how these taxes work will help you to spend your money better and make good financial decisions that include saving more. If you are either earning, spending, or investing – being aware of how taxes actually impact your life will give you a better view of how you are doing financially.