What Is a Direct Tax?
A direct tax is a tax an individual or organization pays directly to the 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.
Understanding a Direct Tax
Direct taxes are based on the ability-to-pay principle. This economic principle states that those who have more resources or earn a higher income should pay more taxes. The ability to charge 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 whom or which the tax is levied is responsible for the fulfillment of the full tax payment. Direct taxes, especially in a tax-bracket system, are thought by some to be a disincentive to work hard and earn 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 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. Both taxes are equally important to the revenue generated by a government and, therefore, to its economy.
- A direct tax is paid by an individual or organization to the entity that levied the tax.
- Direct taxes include income tax, property tax, corporate tax, estate tax, gift tax, value-added tax (VAT), sin tax, and taxes on assets.
- There are also indirect taxes, such as sales taxes, where a tax is levied on the seller but paid by the buyer.
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. Before 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. A state with a population of only 75% the size of another state's, for example, would only be required to pay direct taxes equal to 75% of the larger state's tax bill.
This antiquated verbiage created a situation in which the federal government could not impose many direct taxes, such as personal income tax, 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, $500,000 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 company has no debt, depreciation, or amortization, and has a corporate tax rate of 21%, its direct tax would be $84,000 ($400,000 x 0.21 = $84,000).
Additionally, a person’s income tax is an example of a direct tax. If a person makes $100,000 in a year and owes $33,000 in taxes, that $33,000 would be a direct tax.
Partnerships and sole proprietorships are not subject to corporate taxes.
Other Types of Direct Taxes
The corporate tax is another form of a direct tax. This is the tax that corporations and other businesses must pay to the government on the profits they earn. However, partnerships and sole proprietorships do not pay corporate taxes. The corporate tax in the U.S. is separate from income tax.
Another common type of direct tax is the property taxes property owners pay. These are typically collected by local governments and are based on the assessed value of a property. Other types of direct taxes include estate taxes, gift taxes, value-added taxes (VAT), and sin taxes.