Classification of Taxes: 4 TypesAccording to Prof. J.S. Mill “a direct tax is one ... equitable...

07/04/2019 Classification of Taxes: 4 Types

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Classification of Taxes:

4 Types

Article shared by : ADVERTISEMENTS:

This article throws light upon the four

main types of taxes charged on taxpayers.

the types are: 1. Direct and Indirect Taxes

2. Proportional, Progressive, Regressive

and Degressive Taxes 3. Specific and Ad

Valorum Duties 4. Value Added Tax

(VAT).

Type # 1. Direct and Indirect Taxes:

On the basis of assessment, rather than on thepoint of assess ment, taxes are classified intodirect and indirect.

Direct taxes are imposed by the state uponpersons who are expected to bear the burden ofthese taxes and who are not ex pected to be ableto shift the tax burden to other persons. In otherwords, in the case of direct taxes, impact andincidence are on the one and the same person.

ADVERTISEMENTS:

Indirect taxes are taxes which are im posed uponpersons, who are expected to shift the burden ofthe tax to other persons. In other words, in thecase of indirect taxes, usu ally the impact andincidence will be on different persons.

According to Prof. J.S. Mill “a direct tax is onewhich is de manded from the very person

who, it is intended or desired, should pay

it. Indirect taxes are those which are

demanded from one per son in the

expectation and intention that he shall

indemnify himself at the expense of

another”.



From this definition of Mill, we can real ize thatin the case of direct taxes, the taxpayer and tax-bearer is one and the same person. The shiftingof the tax burden to another person is notpossible or not expected.

Indirect taxes are those in which the taxpayer isnot permanently the tax-bearer. However,shifting of the tax burden is intended or desired.

ADVERTISEMENTS:

Prof. Dalton also made a distinction betweendirect taxes and indirect taxes. According to him“direct taxes are really paid by the person onwhom it is legally imposed, while an indirect taxis im posed on one parson, but paid partly orwholly by another, owing to a consequentialchange in terms of some contract or bargain be -tween them”.

Prof. Shirras attempted to make a distinctionbetween direct and indirect taxes. “Those leviedimmediately on the property and income ofpersons and those that are paid by theconsumers to the state directly are called directtaxes”. Thus according to Prof. Shirras, incometax, wealth taxes, land tax which are directly paidto the state are called direct taxes”.

On the other hand, taxes which affect the incomeand property of persons through theirconsumption may be called as indirect taxes.Thus customs duties, excise duties andcommodity taxes are indirect taxes.

Advantages of Direct Taxes:

(i) Equity:

ADVERTISEMENTS:

Direct taxes are imposed according to the abilityof a person to bear tax burden. Hence, it is moreequitable than indirect taxes. This tax is based onthe principle of progression.



(ii) Certainty:

The taxpayer knows definitely what he has to payand when and why. This enables the taxpayer tomake the req uisite provision for paymentwithout causing hardship to his busi ness.

Likewise, the state obtains correct informationabout the revenue yield from direct taxes, so thatit can accordingly plan the financialprogrammes.

(iii) Economy:

The mode of collection is simple. Tax is collectedat source. The cost of collection is lower. There isno wastage. Since each person knows the exactamount paid by him, gov ernment is compelled tobe economical and careful. Prof. Gladstoneobserves “if you had only direct taxes, you wouldhave economical government”.

(iv) Elasticity:

Direct taxes are more elastic and hence morepro ductive. A slight increase in the rate oftaxation will mean a considerable addition to therevenue yield. Moreover, the yield from directtaxes increases with increase in wealth andincome.

(v) Another advantage of direct taxes is that,since it is collected at the source, there is lesschance of evasion.

(vi) Social Impact:

The taxpayer is directly contributing to the gov -ernment. So he will be very keen to see that thetax money is not wasted and spendunnecessarily.

Hence, taxpayers take intelligent and keeninterest in the financial operations of the state.



Hence, direct tax helps to increase civicconsciousness.

(vii) Distributive Justice:

Direct taxes are based on the canon of ability. Itis basically tuned as per the principle ofprogression. Hence, it can be utilized as animportant and effective tool to reduce the glaringinequality in the distribution of income andwealth in the society.

Disadvantages of Direct Taxes:

(i) Unpopular:

Direct taxes are paid directly by the people.Gener ally it cannot be shifted. Hence it is painfulto the taxpayers. It is more felt by the people andthey are more unpopular.

(ii) Possibility of Evasion:

It is usually said that direct tax is a tax onhonesty. It is not evaded only when the taxpayeris honest and tax collecting machinery isincorrupt. Otherwise, it can be evaded throughfraudulent practices and by furnishing false as -sessment of income returns.

(iii) Another difficulty is the necessity ofassessment, in all direct taxes. Tax taxpayershave the difficulty in producing the neces saryreturns and maintaining the proper accounts.

(iv) Direct Taxes tend to be Arbitrary:

It is difficult to arrive at an objective or just baseof taxation. If imposed on income, prop erty orany other produce, there must be a valuation ofthe ob ject charged. This creates opportunities forarbitrary official ac tion.

Moreover, there is every chance for change in thevaluation method and rate of taxation,



depending upon the political color of thegovernment.

(v) Narrow Base:

A direct tax touches only a section of the com -munity. It is not having wider coverage. The taxbelt is very nar row in the case of direct taxes.

The major drawback of direct taxes emerges outof administra tive inefficiencies. Bastableconcludes the discussion on direct taxes bystating that the defects and merits takentogether, direct taxation ought to be a part ofevery modern financial system and the extent towhich it can be applied will depend on theparticular condition of the country.

Merits of Indirect Taxes:

(i) Convenience:

Indirect taxes are paid indirectly by the taxpayer.They are not felt in the same degree as directtaxes. It is im posed at the time of purchase of acommunity, or at the enjoy ment of a service.

The tax is hidden in the price of the commod itytransacted. Moreover, they are paid in smallamount. Hence indirect taxes cause lessinconvenience to taxpayers.

(ii) Elasticity:

In times of prosperity, indirect taxes are elastic.The revenue yield from this tax can be increased,when necessity arises. But the principle ofelasticity and equity conflict with each other inthe case of indirect taxes.

(iii) No Evasion:

Indirect taxes are generally difficult to evade.They are hidden in the price of the commoditypurchased. When a person buys a commodity, he



will have to pay the tax element. Hence, scope forevasion is very little.

(iv) Wide Coverage:

Indirect taxes fall upon the goods and ser vices. Itis possible to tax every member of thecommunity in one way or another. All citizenscontribute to the revenue source something.Hence, with the help of indirect taxes, tax systemcan be made broad based.

(v) It is More Popular than Direct Taxes:

Indirect taxes are paid indirectly. Its incidence isfelt by all, who purchase the commod ity. Itsincidence is felt through an increase in price.Hence, the burden will not be felt heavily as inthe case of direct taxes.

(vi) Productivity:

If needed indirect taxes can be made productive.Merely by imposing a few taxes, the governmentcan increase its revenue yield.

(vii) It can Promote Social Welfare:

Indirect taxes can perform a social and economicservice to the community. For example, thegovernment can impose stiff rate on articles anddrugs which are harmful to the society. Therebyits consumption can be re stricted.

(viii) It can be made Progressive:

Indirect taxes can be made pro gressive byimposing high rates of taxation on luxury goodsand comparatively lower rates on comforts andsemi-luxury goods. To make it more equitable,articles of mass consumption should beexempted from taxation.

Demerits of Indirect Taxes:



(i) Regressive in Nature:

Indirect taxes on articles of general con sumptionpress more heavily upon the working classes,than on the richer classes.

Such articles are used in larger proportion by thepoor. Hence this tax in reality is not equitable.

(ii) Uneconomical:

Indirect taxes are difficult to administer. Thecost of collection of indirect taxes is very high.They are to be collected from a large number ofpeople in small amounts.

(iii) They are Extremely Uncertain:

The income from indirect taxes is said to beuncertain. The taxing authority cannot accuratelyestimate the total yield from different taxes. Thisis so because demand supply conditions fordifferent goods are influenced by differentfactors. If the demands for taxed commoditiesare elas tic, the income yield may be less and viceversa.

(iv) Social Significance:

Indirect taxes do not promote any civicconsciousness. It is collected in small amountthrough middle men and traders. They are notfelt very much by the taxpayers. Hence nobodytakes much interest in the affairs of the govern -ment.

(v) Inflationary in Nature:

Another demerit of indirect taxes is that theygenerate inflation in the economy. It leads tosharp rise in prices of commodities.

Direct and indirect taxes are complementary toeach other and a modern government relies onboth for its revenue. Both can be made use of



depending on its suitability and efficiency in par -ticular circumstances.

In certain circumstances, it will be better toimpose direct taxes; where as in some othersituation indi rect tax will have better advantages.In the case of realization of equity and efficiency,both taxes are needed.

If a government fully relies on direct taxes, thenthe tax burden will solely depend upon onegroup of taxpayers. The low income groups willbe exempted from the tax liability. In such asituation, taxpayers will try to evade their incometax.

The tax evading group can be brought under thepurview of tax belt, if this evaded income isappraised indirectly at the time when it is spent.Likewise, the lower income may be taxed lightlyby imposing small percent age of taxes onessential consumer goods. Hence, both taxes areneeded for a balanced tax system.

Prof. De Macro observed that the co-ordinatedaction of direct and indirect taxes makes possiblea more elastic tax system capable of bringingabout a more delicate and precise distribution oftaxes. Both types of taxes have relative meritsand demerits. They are complementary ratherthan competitive.

For the reduction of inequality in incomedistribution both taxes should be adopted.Likewise, in creased revenue requirement can bemet by both types of taxes. An ideal tax systemshould consist of a judicious combination of bothtypes of taxes. A proper balance should bemaintained between direct and indirect taxes.

There is no virtue attached to any particu larproportion as the ideal balance. It depends uponthe economic condition of the country concernedand revenue requirements.



In this context, Prof. Gladstone observes “directand indirect taxes are like two attractive

sisters, between whom he was perfectly

impartial without one being superior to

the other”. Hence, a country’s tax systemshould consist of both direct and indirect taxes inthe needed proportion.

Direct and Indirect Taxes: A Comparative

Analysis:

Direct and indirect taxes are compared on thebasis of allocation of resources, distributive effectand administrative point of view.

(i) Allocative Effect:

In terms of Allocative effect, direct taxes areconsidered superior to indirect taxes. It simplymeans that if a given amount of money is to becollected through taxes, the burden or sacrificeinvolved would be greater in the case of indi recttaxes, than direct taxes. The indirect taxes placeconsum ers in worse position than direct taxes.This can be illustrated with the help of theindifference technique (Figure No. 4.6).

Allocative Efficiency of Direct and Indirect Taxesand PA price line. The indifference curve Ctouches the price line PA at the point QTherefore the consumer with QP amount of in -come will be able to purchase QA quantity ofcommodity ‘x’.

1

1



His pre-tax equilibrium is represented by thepoint Q at which the price line is tangent to hisindifference curve IC . Now a commodity tax isimposed and the price increases by the fullamount of the tax.

The post taxed price line is PA , and theconsumers equilibrium is at Q which is the pointof tangency between his indifference curve ICand the price line PA The consumer canpurchase only OR now, in stead of ON, byspending an amount equal to PD. Of this amounttax equals SQ , the vertical distance between PAand PA.

The consumer is on a lower indifference curveIC . Now suppose that the same amount of taxyield (SQ ) is raised by way of direct taxes, sayfor example income tax instead of commoditytax.

The consumers income will be reduced by the taxamount, i.e. PP (=SQ ). Since the price of thecommodity remains unchanged, the new priceline will be P A , which is parallel to PA. Thisshows that the consumer’s disposable income isnow QP , which can buy ON amount of quan tity.

Under the circumstances the equilibriumposition will be changed to a point on the priceline P A , to the right of Q , say at Q , where theindifference curve IC is tangent to the price line.The new equi librium places the consumer at ahigher indifference curve than be fore.

The inference is that an equal yield indirect taxreduces consumer’s welfare by larger magnitudethan a direct tax. Hence it can be concluded thatdirect tax is less harmful in its effect onallocation of resources than indirect tax.

(ii) Administrative Aspect:

1

3

1

2

2

1

2 1

2

2

1 2

1 2

1

1 2 2 3

3



On the basis of administrative cost andefficiency, direct and indirect taxes can becompared. In the usual parlance direct taxes arenot imposed on low incomes because ofadministrative point of view. Direct taxes make itnecessary to check and scrutinize the eachtaxpayers account. This is a herculean task. Forthis purpose a large number of employees areneeded.

It involves a complex and efficient ad ministrativemachinery to look after the tax structure.Whereas cost of collection of indirect taxes issmaller than direct taxes. In direct taxes arecollected not from the innumerable buyers andsellers of goods, but from the businessmen andwholesal ers. The collection cost andadministrative cost is compara tively low inindirect taxes.

Prof. Prest supported indirect tax on the groundof administra tive cost and provided the followingjustification for indirect taxes.

For instance, when there are large numbers ofsmall, indepen dent, producers or illiteratepeople, who are incapable of main tainingaccounts and when most of the people are livingat sub sistence level, indirect taxation may bemore desirable than di rect taxation. Hence, in anunderdeveloped country, indirect taxa tion isgood.

(iii) Distributive Aspect:

It is a commonly accepted fact that direct taxespossess certain inbuilt mechanism to achieveredistribu tion of income in favour of the poorclass. Direct taxes are gen erally progressive innature.

Hence they fall more heavily on the rich than onthe poor. On the other hand indirect taxes fall onall incomes and hence they are generally



regressive in character hence, argument goes infavour of direct taxes as an effective tool toreduce income inequality.

However, the fact is that if indirect taxes aremade selective they can also contribute towardsreducing the glaring inequality in in comedistribution. By taxing heavily on those articlesof consump tion, consumed by rich people andexempting those articles con sumed by poorcommunities, the tax structure can be mademore equitable.

Prof. Prest observes “over a wide range,direct and indi rect taxes are alternative

methods of achieving any particular redis

tribution of income on which the

government of the day may be bent”.

(iv) Stabilization Aspect:

Direct taxes act as automatic stabilizers duringperiods of economic fluctuation. In inflationaryperiod, they go up more than proportionatelywith an increase in GNP, whereas during periodsof recession they decline more than proportion -ately to the decline in GNP.

Thus direct taxes possess built-in- flexibility. Butindirect taxes do not possess such flexibility, be -cause consumption tends to rise or fall less thanproportion ately in income.

(v) Economic Growth Aspect:

In developing economies, indirect taxescontribute more to economic growth bycurtailing con spicuous consumption andundesirable investments. Whereas high rates ofincome and corporate taxes may discourage in -vestment and growth.

Type # 2. Proportional, Progressive,

Regressive and Degressive Taxation:



On the basis of method, that is the rate oftaxation; taxes are clas sified and compared intoproportional, progressive, regressive anddegressive.

Prof. Taylor defined proportional,

progressive, regressive and degressive

taxation as follows:

(a) Proportional Taxation:

“A schedule of proportional tax system is one atwhich the rate of taxation remains constant asthe tax base changes”. In other words when therate of taxation remains the same for all incomes(or property) large or small, then we haveproportional taxation.

The tax is fixed as certain percentage of theincome or the price or value of an item. Prof.Taussing describes proportional taxation assimply the fiscal principle of taxation whichholds that the existing distribution of propertyand income should not be disturbed by taxation.

Taylor observes that this taxation unquestionablycarries simple impli cations of justice andequality. In this system amount of tax payable iscalculated by multiplying the tax base with taxrate. For example, the rate of income tax may be20% on all in comes, or rate of wealth tax may be10% for all incomes.

The following hypothetical table and

graph explain the point more clear:

(b) Progressive Taxation:

“A schedule of progressive tax system is one inwhich, the rate of taxation increases as the taxbase increases”. That is if the rate of taxationincreases as the in come (or property) increases,then we have progressive or gradu ated taxation.



Moreover, a tax is progressive, if it is graduatedin such a way that the rate of tax rises, moresharply than the increase in income or capital.The amount of tax payable is calculated bymultiplying the tax base, with the tax rate.

The hypothetical table and graph given

below explain the concept more clearly:

(c) Regressive Taxation:

“A schedule of regressive tax rate is one in whichthe rate of taxation decreases as tax baseincreases”. In other words, if the rate of taxationdiminishes as the income or property increases,we have regressive taxation.

Taxes that are unrelated to the taxpayer’s abilityto pay are regressive. The amount of tax payableis calculated by multiplying tax base with taxrate.

The hypothetical table and graph given

below illustrate the point clear:

(d) Degressive Taxation:

If the rate of taxes increases, faster than incomeor property but towards a fixed maximum rate,which it can never exceed, it is known asdegressive taxation. Degression is a special caseof progression where the acceleration of the tax



rate decrease as the tax base increases. Thesetypes of taxes are mildly progressive, but not verysteep.

Hence high income do not make due sacrifice. Indegressive taxation a tax may be slightlyprogressive up to certain limit, after that it maybe charged at a flat rate. Here also the amount oftax payable is calculated by multiplying the taxbase with tax rate. The hypo thetical table andgraph makes the definition clear and under -standable.

Type # 3. Ad Valorem and Specific

Duty:

1. Advalorem Duty:

When a tax is levied on the basis of the value of acommodity or property it is known as Ad-valorem duty. This duty is expressed as apercentage of the value of a commodity. In thiscase irrespective of the weight and size of thecommodity, tax is charged purely accord ing to itsvalue.

Several imported commodities are chargedaccord ing to this value. For example, an importor export duty is levied at the rate of 20 paisa perrupee or 2% of the value of goods. Ad-valoremduties impose greater burden on the richerincome group. Hence in the case of distributionof tax burden, it satisfies the canon of equity. Ad-



volrem duty encourages the production of lowpriced goods.

However, Ad-valorem duty has the followingdrawbacks. It is very difficult to know the realvalue of a commodity, at the time of imposi tionof a tax. Moreover, there is wide scope for taxevasion, when traders understate the value of thecommodity.

Some fiscal theorists argue that Ad-valorem dutylead to price rise and they generate infla tionarypressure. It is also stated that Ad-valorem dutiesare difficult to administer. Disputes regardingvaluation may frequently arise in this case.

2. Specific Duties:

When a tax is imposed on a commodity as per itsweight, it is called specific duty. Specific dutiesare expressed as definite sums to be paid for thedefinite weight of a commodity. For example,when the excise duty is imposed as rupees tenper quintal or excise duty on cloth as ten paiseper meter, it is a case of specific duty. In both thecases, weight and length is used as the basis oftaxation.

The most important advantage of specific duty isthat it is easy to levy and very convenient tocollect. However, specific duties result in higherrevenue, only when there is an increase in thephysical volume of output.

Hence, any improvement in quality of output willnot fetch additional revenue to the government.Specific duties tend to be regressive. It failsheavily on cheap varieties of goods which areconsumed by the lower income group. It leads toproduction of expen sive varieties ofcommodities.

Type # 4. Value Added Tax (Vat):



Value added tax (VAT) belongs to the family ofsales tax. It is of recent origin. This tax has beenadopted as an important tool to impart greaterflexibility to the revenue base of an economy.VAT is not a tax on the total value of goods beingsold. It is a tax on the value added to the good bythe last seller. The seller therefore is liable to paya tax not on the gross value, but on net value.

Net value means gross value minus value ofmaterial purchased from other firms. The salientfeature of VAT is that it falls on the value addedat each stage from the stage of production toretail stage. The Jha committee defined VAT as atax on all goods and ser vices, the specialcharacteristics being that it falls on the valueadded at each stage, from the stage of productionto the retail stage.

How ever, in practice, VAT is charged on eachtaxpayer after deducting from the tax payable onhis output, the tax he has paid on his input. Thusit gives a comprehensive system of commoditytaxation to a country.

VAT possesses certain advantages. It eliminatessome of the prob lems associated with doubletaxation. Moreover, it helps to reduce the taxevasion done under the sales tax system. Anotherargument in favour of VAT is that it will notadversely affect the allocation of resourcesbetween different industries. It is simple toadminister and satisfies the canon of economy.

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Classification of Taxes: 4 TypesAccording to Prof. J.S. Mill “a direct tax is one ... equitable...

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