Direct Tax

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What is a 'Direct Tax '

A direct tax is paid directly by an individual or organization to an imposing entity. A taxpayer, for example, pays direct taxes to the government for different purposes, including real property tax, personal property tax, income tax or taxes on assets. Direct taxes are different from indirect taxes, where the tax is levied on one entity, such as a seller, and paid by another, such as a sales tax paid by the buyer in a retail setting.

BREAKING DOWN 'Direct Tax '

Direct taxes are based on the ability-to-pay principle. This principle is an economic term that states that those who have more resources or earn higher income should pay more taxes. The ability to pay taxes is a way to redistribute the wealth of a nation. Direct taxes cannot be passed onto a different person or entity; the individual or organization upon which the tax is levied is responsible for the fulfillment of the full tax payment.

However, this sometimes acts as a negative. Direct taxes, especially in a tax bracket system, can become a disincentive to work hard and earn more money, because the more money a person earns, the more taxes he pays.

The History of Direct Taxes

The modern distinction between direct taxes and indirect taxes came about with the passing of the 16th Amendment in 1913. Prior to the 16th Amendment, tax law in the United States was written so that any direct taxes were required to be directly apportioned to the population. For example, a state with 75% of the population in relation to another state would only be required to pay direct taxes equal to 75% of the larger state.

This antiquated verbiage made it so many direct taxes, such as personal income tax, could not be imposed by the federal government due to apportionment requirements. However, the passing of the 16th Amendment changed the tax code and allowed for the levying of numerous direct and indirect taxes.

An Example of Direct Taxes

Corporate taxes are a good example of direct taxes. If, for example a manufacturing company operates with $1 million in revenue, $500,00 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 company had no debt, depreciation or amortization, and had a corporate tax rate of 35%, its direct tax would be $140,000, derived as: ($400,000 * 0.35) = $140,000.

Additionally, a person's income tax is an example of a direct tax. If a person makes $100,000 in a year and owes $40,000 in taxes, the $40,000 would be a direct tax.

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