What is a direct tax?
A direct tax is paid directly by an individual or an organization to the imposing entity. A taxpayer, for example, pays direct taxes to the government for various purposes, including property tax, personal property tax, income tax, or asset tax.
Understanding direct taxation
Direct taxes are based on the principle of ability to pay. This principle is an economic term which states that those who have more resources or earn higher income should pay more taxes. The ability to pay taxes is a means of redistributing the wealth of a nation. Direct taxes cannot be passed on to another person or entity; the person or organization from which the tax is levied is responsible for making full payment of the tax.
Direct taxes, especially in a tax bracket system, can discourage working hard and earning more money because the more money a person earns, the more taxes they pay.
A direct tax is the opposite of an indirect tax, where the tax is collected on one entity, like a seller, and paid by another, like a sales tax paid by the buyer in a retail setting. Both taxes are also important for the revenue generated by a government and, therefore, for the economy.
The history of direct taxes
The modern distinction between direct and indirect taxes appeared with the adoption of the 16th Amendment in 1913. Before the 16th Amendment, United States tax law was drafted so that all direct taxes were to be directly charged to the population. For example, a state with 75% of the population compared to another state would only be required to pay direct taxes equivalent to 75% of the larger state.
This archaic verbiage means that so many direct taxes, such as personal income tax, could not be imposed by the federal government because of the distribution requirements. However, the adoption of the 16th amendment modified the tax code and allowed the collection of many direct and indirect taxes.
An example of direct taxes
Corporate tax is a good example of direct taxes. If, for example, a manufacturing company operates with $ 1 million in revenue, $ 500,000 in cost of goods sold (COGS) and $ 100,000 in total operating costs, its earnings before interest, taxes, depreciation, and amortization ( EBITDA) would be $ 400,000. If the corporation had no debt, depreciation or amortization and had a corporate tax rate of 35%, its direct tax would be $ 140,000, calculated as follows: ($ 400,000 x 0.35 ) = $ 140,000.
In addition, a person’s income tax is an example of a direct tax. If a person earns $ 100,000 in a year and owes $ 40,000 in taxes, that $ 40,000 would constitute direct tax.
Other types of direct taxes
Corporation tax is another form of direct tax. It is the tax that corporations and other businesses have to pay the government on the profits they make. However, partnerships and sole proprietorships do not pay corporate tax. In the United States, corporate tax is separate from income tax.
Another type of direct tax is the property tax, paid by the owner of a property. These are usually collected by local governments and are based on the estimated value of a property.
Other types of direct taxes include estate taxes, gift taxes, value added taxes (VAT) and sin taxes.