Direct and indirect taxes

As the saying goes “Nothing is certain, but death and taxes” and it rings true, since taxes are a part of your daily life whether you like it or not. You might even be paying taxes that you have no idea about. Since 1950, individual income taxes have been the primary source of revenue for the U.S. federal government. Along with payroll taxes, income taxes amount to around 80% of all federal revenue, which is needed for the government to be able to run effectively.

There is a general distinction between direct and indirect taxes, but how do the two types of taxes differ from one another and which taxes fall into each of the categories?

Direct taxes

A direct tax is paid directly to the government by an individual or organization. For example, a homeowner pays personal property taxes directly to the government, and a family pays its own federal income taxes. Direct taxes cannot be shared or passed onto other parties.

A provision in the U.S. Constitution states that any direct taxes imposed by the national government should be shared among the states depending on their population. The amount of direct tax each person pays depends on their wage. The “ability-to-pay” principle means that those who earn more, should also contribute more in taxes.

Here are some examples of direct taxes:

Income tax

An individual pays income tax based on their taxable income during the financial year. Federal, state, and local governments levy income taxes on personal wages and business profits. The U.S.’s progressive income tax system works in a way in which those that earn more get taxed more, but there are ways of lowering tax liabilities (e.g. donating to charity, contributing to a retirement account, etc.).

Employees usually find their taxes deducted from their paycheck each month, and companies pay income taxes on a quarterly basis. These payments are estimated so it could be that the taxpayer either has to pay more at the end of the year, or they receive a refund for the amount they’ve overpaid.

Entitlement taxes

Entitlement taxes are collected by the federal government in order to pay for social programs such as Medicaid, Medicare, Social Security, and others. This tax is deducted from the individual’s paycheck and is grouped into “Federal Insurance Contributions Act” (FICA) payments. Self-employed people and companies must also pay entitlement taxes in their quarterly tax payments.

Transfer taxes

If ownership of property is passed from one person to another without money changing hands, this is when transfer taxes come into play. They are imposed by federal, state, and local governments. Gift and estate taxes are the most widely known examples of transfer taxes. Gift taxes are collected when money or property is transferred to another person. Estate taxes are collected from the taxable portion of a deceased person’s estate.

Property taxes

Buildings and landowners must pay property tax to the state and local governments so that local public services such as police and fire departments, schools, libraries, and roads can be financed. How much the owner pays depends on the size of the land or building. In order to work out the value of the property, the worth is calculated annually to take fluctuations into account. Property taxes can also fluctuate based on local budget needs.

Capital gains taxes

Capital gains taxes are collected when assets e.g. real estate, artwork, stocks, etc. are being sold. The tax is calculated depending on the price of the item when it was first bought, and the price it is worth at the point of sale. The tax rate is lower for these types of transactions, since inflation can affect capital gains. It’s possible to deduct a portion of the capital loss if the asset is sold for less than it was bought for.

Indirect taxes

Indirect taxes are collected by someone in the supply chain (i.e. a producer or retailer) and then paid to the government. The consumer essentially pays the tax by paying more for a product, since the tax is added on top of the price. The difference therefore between direct and indirect taxes is that in the case of direct taxes, the individual pays the tax directly to the government, but when it comes to indirect taxes, the individual pays the tax to someone else, who then pays it to the government: a bit like a middleman.

Examples of indirect taxes include liquor, fuel, import duties, and cigarette taxes. Some indirect taxes are referred to as consumption taxes e.g. value-added taxes (VAT). Here is an example of the most common indirect tax, import duties: the duty is paid by whoever is importing the goods when they enter the country. If this person then sells the goods to a customer, the cost of the duty is technically hidden in the amount that the customer is paying. So they are paying indirect taxes and maybe aren’t even aware of it.

Here are some examples of indirect taxes:

Sales taxes

When you go grocery shopping, you’re given an amount to pay at the cash register. This amount actually includes a percentage of the purchase, usually between 4% and 10%, which is the sales tax. The sales tax is sent to local, state, and federal agencies, where it is used for different programs and projects. Sales tax is also imposed on larger goods such as homes and vehicles.

Sales taxes are an example of a tax that falls into both categories; direct and indirect. They are classified as direct taxes if they are imposed only on the final supply to a consumer, but if they are imposed as value-added taxes during the production process, then they count as indirect taxes.

Customs taxes

These are imposed on imported and exported products, but many customers often aren’t aware of the taxes imposed on imported and exported goods. Everyone pays them regardless of how much they earn. Manufacturers and merchants often charge customers higher prices to make up for the fact that they have to pay taxes when buying or selling raw materials or finished products.

Fuel taxes

When you buy gasoline for a vehicle, you pay indirect taxes. This tax is hidden in the price per gallon so you might not be aware of it. Fuel tax (also known as “gas tax” or “fuel duty”) is sometimes used as an ecotax to promote ecological sustainability. This article on fuel taxes shows you how much each state pays per gallon. Pennsylvania pays the most at 58.7 cents per gallon and the state paying the lowest is Alaska at 14.7 cents per gallon (as of 2018).

Excise taxes

Excise taxes are paid when purchases are made on specific goods, such as gas, and are often included in the price of the product. For manufacturers, this tax applies to business costs, meaning they somehow need to “get it back” – which is why the customer pays it when they purchase the finished item. Excise taxes can also be temporary e.g. the sugar tax in 1898, but some taxes are here to stay, such as those imposed on gasoline, tobacco, and alcohol.

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