Definition of Direct & Indirect Taxes

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Property and income taxes generally are considered direct taxes although, constitutionally, they aren't.
Property and income taxes generally are considered direct taxes although, constitutionally, they aren't. (Image: private property image by Jane from Fotolia.com)

Defining a tax as direct or indirect is complicated by whether you use legal or economic definitions. Generally speaking, income taxes and property taxes are considered direct taxes because the taxes levied are collected directly from individuals based solely on an “ability to pay” principle. Indirect taxes, sometimes called “consumption taxes,” include sales taxes, excise taxes, value-added taxes (VAT) and customs taxes. These taxes are often referred to as “regressive” taxes because they’re not based on one’s ability to pay the tax, unlike direct or “progressive” taxes.

Direct Tax: Income

Technically, income tax is not a direct tax, although you’d be hard-pressed to find an economist or lawyer to say otherwise. The Sixteenth Amendment to the U.S. Constitution, which most people recognize as the beginning of federal income taxes, was ratified in 1913 and specifically divorced income taxes (and all taxes collected by the federal government) from “apportionment” clauses within the Constitution, making income and property taxes collectible without violating the Constitution. The one-sentence Sixteenth Amendment reads:

“The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

Despite these legislative gymnastics, income taxes — federal, state and local — are, for all intents and purposes, direct taxes. The burden of paying these taxes falls directly on individuals and businesses. You don’t have to do anything other than earn money to be liable for income taxes. Corporation taxes and FICA (social security) taxes also are forms of direct taxes based solely on income and wealth. Direct taxes on income, business earnings and wealth are almost always progressive in nature, meaning that a person’s or company’s ability to pay and how much they earn is a factor in the tax amount levied.

Direct Tax: Property

There are no federal property taxes, but local municipalities impose property and real estate taxes as a form of direct taxation. Property taxes are not levied by states but by cities, towns, villages, school districts and other local government entities, although states often play an enforcement role in collecting delinquent property taxes. States also regulate and specify market-value and assessment procedures for determining the value of homes, although significant tax breaks are provided in many states, such as for senior citizens. Property tax “circuit breaker” laws have been instituted in some states to offer property tax relief to homeowners who are elderly and cannot afford property taxes as the value of their homes increases. According to the U.S. Census Bureau, New York and New Jersey had the highest property-tax rates in the United States, and Louisiana had the lowest.

Indirect Tax: Sales

The most visible of consumption taxes is the sales tax, which is an indirect tax because it is levied on specific items or services. Consumption taxes are popular forms of revenue raisers for politicians because certain goods and services can be targeted for increased sales taxes. So-called “vice” or “sin” taxes, which target items like cigarettes and alcohol, or services such as gambling, usually are the first items targeted when tax revenues begin to fall. Sales taxes are imposed upon business activities and not directly on people or businesses. For example (the theory goes), you can decide to not purchase cigarettes, new cars and jewelry. Individuals determine how much they pay in sales taxes through the choices they make. That theory is why most states have repealed sales taxes on life necessities, like food items (although the same logic seems to be absent regarding taxes on shelter). Sales taxes are imposed on customers and collected by businesses.

Indirect Tax: Excise

Excise taxes are levied on businesses and not consumers (although, in reality, consumers end up paying the cost of an excise tax). Some states, such as Hawaii, impose excise taxes exclusively in lieu of sales taxes. Businesses are not merely tax collectors in an excise tax system, but are directly taxed on their gross incomes. Excise taxes are business expenses — just like labor, utility, supplies and other costs. Excise tax rates vary among states and from industry to industry, service to service, and from business to business. Excise taxes (or excise duties) are charged on goods produced within the country. Customs duties are taxes imposed on foreign-produced goods. Use and transaction taxes also are forms of excise taxes.

Indirect Tax: VAT

VAT (value-added taxes) is the added value to a product by a business, and is the price charged to customers minus the cost of materials and other business costs and taxes. VATs are charged throughout the production cycle of a good. A VAT, from a consumer point of view, is a sales tax in that, ultimately, only consumers are taxed.

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