A direct tax is a tax that a person or organization pays directly to the entity that imposed it. Examples include income tax, real property tax, personal property tax, and taxes on assets, all of which are paid by an individual taxpayer directly to the government.
Key Takeaways
- A direct tax is paid by an individual or organization to the entity that levied the tax.
- Direct taxes include income taxes, property taxes, and taxes on assets.
- There are also indirect taxes, such as sales taxes, wherein a tax is levied on the seller but paid by the buyer.
Grasping the Concept of Direct Tax
Direct taxes in the United States are largely based on the ability-to-pay principle. This economic principle states that those who have more resources or earn a higher income should bear a greater tax burden. Some critics see this as a disincentive for individuals to work hard and earn more money because the more a person makes, the more taxes they pay.
Direct taxes cannot be passed on to a different person or entity. The individual or organization upon which the tax is levied is responsible for paying it.
A direct tax is the opposite of an indirect tax, wherein the tax is levied on one entity, such as a seller, and paid by another—such as a sales tax paid by the buyer at a retail setting. Both kinds of taxes are important revenue sources for governments. Examples of indirect taxes include excise duties on fuel, liquor, and cigarettes; as well as a value-added tax (VAT), also referred to as a consumption tax.
The Evolution of Direct Taxation
The modern distinction between direct taxes and indirect taxes came about with the ratification of the 16th Amendment to the U.S. Constitution in 1913. Before the 16th Amendment, tax law in the United States was written so that direct taxes had to be directly apportioned to a state’s population. A state with a population that was 75% of the size of another state’s, for example, would only be required to pay direct taxes equal to 75% of the larger state’s tax bill.
This antiquated verbiage created a situation in which the federal government could not impose many direct taxes, such as a personal income tax, due to apportionment requirements. However, the advent of the 16th Amendment changed the tax code and allowed for the levying of numerous direct and indirect taxes.
Practical Examples of Direct Taxes
Corporate taxes are a noteworthy example of direct taxes. For instance, if a manufacturing company reports $1 million in revenue, $500,000 in the cost of goods sold (COGS), and $100,000 in operating costs, its earnings before interest, taxes, depreciation, and amortization (EBITDA) would be $400,000. If the company has no debt, depreciation, or amortization, and has a corporate tax rate of 21%, its direct tax would be $84,000 ($400,000 x 0.21 = $84,000).
An individual’s federal income tax exemplifies another direct tax. If a person earns $100,000 in a year and owes the government $20,000 in taxes, that $20,000 is a direct tax.
Other common direct taxes in the United States include property taxes that homeowners are required to pay, which are typically collected by local governments based on the assessed value of the property.
Additional types of direct taxes in the U.S. and elsewhere encompass use taxes (such as vehicle licensing and registration fees), estate taxes, gift taxes, and so-called sin taxes on items like liquor and cigarettes.
Frequently Asked Questions About Direct Taxes
What Are Examples of Direct Taxes?
Direct taxes are taxes paid directly to the party that levied them, such as the IRS. Common examples include income tax, capital gains tax, or property tax that a taxpayer pays to the government.
What Is the Difference Between Direct and Indirect Taxes?
Direct taxes cannot be shifted to another party and remain your responsibility to pay. Indirect taxes, on the other hand, can be passed on or shifted to another person or group.
What Are Some Examples of Indirect Taxes?
Common examples of indirect taxes include sales tax, excise tax, value-added tax (VAT), and goods and services tax (GST). Often, businesses pass these costs onto individual consumers by charging higher prices.
Related Terms: indirect tax, sales tax, excise tax, value-added tax, taxation principles.
References
- Internal Revenue Service. “Understanding Taxes: Direct and Indirect Taxes”.
- Constitution Center. “Direct and Indirect Taxes”.
- Internal Revenue Service. “Historical Highlights of the IRS”.
