Which tax system is regressive: Direct tax or Indirect tax?

Every year in its annual budget (also known as Annual Financial Statement) the Government provides details of how much money it expects to reap from various sources and how it intends to spend the funds. As of now, the Government of India earns about 80% of its total revenue through taxes and the remaining 20% from non-tax revenue like dividends earned from profits of public sector enterprises, interest, fines, regulatory charges, etc. Paying taxes under a direct tax system or indirect tax system or under both systems is inevitable. But how much of an impact they have on taxpayers is depends on direct and indirect tax systems.

The Indian government’s Department of Revenue is the central authority that exercises control in matters relating to all the direct and indirect taxes through two statutory boards: the Central Board of Direct Taxes (CBDT) and the Central Board of Indirect Taxes and Customs (CBIC).

Direct Taxes:

Income by way of salary, pension, interest, royalties, and dividends, earned by individuals in excess of the threshold limit is taxable. The tax collected by the Government directly from the above type of taxpayers is known as a direct tax. Technical services fees profit earned through business, capital gains tax, gains through the sale of assets based in India, surcharge, and health and education cess on total tax payable,   are other examples of Direct taxes. Besides the above types of taxes, corporate taxes like Minimum Alternate Tax (MAT) Levied on zero tax companies whose accounts are prepared as per the guidelines of the Companies Act, Fringe Benefits Tax,    Dividend Distribution Tax (DDT) are also considered as direct taxes.

Indirect Taxes:

Indirect Taxes are essentially the taxes that are not directly levied on the Income of an individual but are indirectly levied on the goods and services bought by the consumer. The Goods and Services Tax (GST) is a single domestic indirect tax law for the entire country which has replaced many indirect taxes in India such as excise duty, VAT, services tax, etc. However, there are some other indirect taxes that have not been brought under the radar of GST. Customs duty, security transaction tax, building, and welfare cess, and electricity duty levied by local authorities and state governments are some of these indirect taxes. Usually, the indirect tax levied on the sellers of goods or providers of the service will be passed on to the buyer of the product or user of the service and therefore ultimately it is the consumer who bears this tax. The burden of tax cannot be shifted in the case of direct taxes while the burden can be shifted to the ultimate user in the case of indirect taxes.

Progressive tax system and regressive tax system:

A progressive tax imposes a greater percentage of taxation on higher income levels, operating on the theory that high-income earners can afford to pay more. In view of higher tax percentage being levied on people earning higher income under the direct tax system, that tax system is considered as the progressive tax system. For example, under the direct tax system, the income tax percentage rate increases at intervals when taxable income increases. This results in a higher tax rate to the taxpayer once his income amount hits a new threshold. Thus, direct taxes are beneficial in reducing income inequalities as the government levies higher taxes on taxpayers who can afford them and uses this money to help the poor, which reduces income inequality.

Under the indirect tax system, there is no correlation with an individual’s earnings or income level of the taxpayer. Even in the case of the direct tax system, if the tax is levied at a uniform rate for all slabs of income, it is treated as a regressive system as it does not differentiate the low-income earners and high-income earners while levying taxes. The regressive taxes may seem fair because they are imposed on everyone regardless of income. However, this system hurts low-income earners more than the rich. For example, indirect tax paid on salt, soap, toothpaste, etc. is the same for the poor and rich. Hence, the indirect tax system hurts the low-income groups and middle-income groups more, because they spend a larger portion of their income on regressive taxes than people who earn more.

The Indian tax system is a regressive tax system:

Direct taxes are considered more equitable. In most developed countries like the United States, Canada, Chile, Colombia, Mexico, Costa Rica, Australia, Japan, Korea, and New Zealand, Israel, Turkey, Austria, Belgium, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Latvia, Lithuania, Luxembourg, Netherlands, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, and the United Kingdom, the share of direct taxes in the total taxes collection is far more than the indirect taxes. According to the latest data, these countries’ average for direct tax collection in 2018 was 67.3% of the total tax collection. While for India, it was 38.3% for Financial Year 2019. In Financial Year 2021, India’s direct tax collection stood at Rs 9.45 lakh crore while the indirect tax collection was at Rs 10.71 lakh crore. In 2020-21, direct taxes had a share of 4.7% of GDP, while indirect taxes’ share in GDP was about 5.4%.

Conclusion: Low direct tax and higher indirect tax suggest that the tax burden is shifting towards the poor.