Classification or Types of Taxes

Classification According to Impact of Tax

  • Direct tax
  • Indirect tax

Direct Tax

Direct taxes occur when impact and incidence of tax are on the same person. It is not possible for such an individual to shift any part of tax to anybody else. The examples include: personal income tax (PAYE), death duty, profits and property of individual, corporation tax, stamp duty (tax paid in areas e.g. conveyancing of land or securities transfer from one person to another), wealth tax which is levied on personal wealth that goes beyond a certain limit i.e. on land, houses, accumulated profits, savings and all realizable assets, motor vehicle licence fees, fuel levies paid by motorists companies capital transfer tax and capital gains tax.

Merits of Direct Taxes

  • Economical in collection
  • Enhances equality and fairness because payment is based on size of citizen’s income.
  • Tax revenue is certain as the government can compile income categories as well as contributors in each category from annual returns made by tax contributors. The tax payer also knows how much to pay.
  • The society is conscious(civic conscious) as the tax payer feels the pinch of paying tax and is therefore keen in examining expenditure ensuring the government uses correctly what it collects.
  • There are no leakages as the taxes are mostly paid directly to tax authorities and not collected by middlemen.
  • Elasticity is enabled as they can be expanded to cover as many areas as desirable. In periods of decreased economic stability, tax rates are reduced to ensure people have money to spend.
  • Does not affect price of goods and services as this tax is not inflationary as it only affects consumers’ disposable incomes and not the price of goods and services.
  • Brings redistribution of wealth and this is mainly seen in progressive tax system where wealthier members are taxed more than poorer. The finances obtained from wealthier members are used to finance services that benefit poor members of community.
  • Usually simple to understand by both the contributor and collector.
  • Desirable as it only affects people who fall within the jurisdiction of income tax and corporation tax.
  • Flexible as this tax is elastic i.e. can be raised or reduced according to needs of the society.

Demerits of Direct Taxes

  • Possible tax evasion by either falsifying information or just ignoring payments
  • Unpopular with citizens as the burden of tax is borne by tax payer directly.
  • No consultations are made of tax payers
  • In most developing countries most people have low incomes and the government of these countries rely on direct taxes as the main source of revenue
  • It is not imposed on all citizens i.e. low income earners outside tax brackets are exempted and this makes them not contribute anything to state and they are therefore not interested in scrutinizing government expenditure to ensure proper use of resources.
  • It is a deterrent to saving as high taxation on peoples income would reduce their ability to save as it leaves them with less disposable income.
  • Encourages capital flight because direct taxes like corporation taxes encourage capital flight from the country. This is because the high taxes in country force foreign investors to withdraw their investments and transfer them to countries with lower taxes.
  • Inconvenience as the tax payer has to submit statement of his total income along with the sources of income from which it is derived which is generally subject to complications.
  • Possibility of injustice as it is difficult to access income of all classes accurately. Hence, it may not fall with equal weight on all classes. Moreover direct taxes are arbitrary fixed by the government and they may not be dealt on basis of ability to pay.

Indirect Tax/Commodity Tax

This is a type of tax whereby the person on whom it is initially imposed may not shoulder the whole tax burden but may shift either the whole or part of it to someone is usually based on consumption of goods and services. Examples include: VAT, import duty, export duty (discourages exports) etc.

Merits of Indirect Tax

  • Coverage: the government raises high amounts because taxes are levied on a wide range of essential commodities and every member of community will be taxed.
  • Convenient because it is not paid in lump sum but in small bits as one buys the commodity and the pinch is not experienced and tax is hidden in price of commodity and therefore the payer may not be aware of it.
  • Difficult to evade because all those who buy the taxed commodity have to pay the tax.
  • Ease of collection: indirect taxes are collected by manufacturers and sellers of goods and services and then remitted in lumpsum payment to tax authorities.
  • Promotes social welfare e.g. harmful products like cigarettes and alcoholic drinks may be taxed heavily to discourage their consumption.
  • Can be used selectively to achieve a given objective like price i.e. high tax is likely to increase product price.
  • Promotes equality as this tax is charged at fixed rates to all the people in the society.
  • It is flexible/elastic as it enables the government to either raise or reduce tax rate to suit the prevailing economic situation in the country. Any slight increase in tax rate greatly increases the revenue.
  • Tax payment is voluntary e.g. if one doesn’t want to pay tax, he/she would only need to avoid the taxed commodity i.e. those who do not take beer don’t pay tax on it.
  • Stimulates effort as increase in this tax is likely to stimulate effort as people struggle to maintain their current standards of living.

Demerits of Indirect Tax

  • Uncertainty in revenue yield as one may not predict the amount of revenue as it is not easy to forecast sales.
  • Expensive to administer as the state has to employ many tax inspectors who ensure that the correct amount of taxes are being collected and remitted to tax authorities.
  • Regressive/less equitable as the burden falls more heavily on consumers with low incomes compared to high income earners
  • May fuel inflation/increase price of commodities
  • Encourages falsification of records as revenues depends on the sales recorded by traders so as to pay less.
  • Lacks contributors’ awareness, thus tax payers do not take an active interest in government spending.
  • Leads to low savings due to increasing tax and the extra income consumers could have saved and invested decreases as consumers pay more for goods and services.
  • Impartial/can be avoided as it usually targets few sets of goods e.g. cigarettes, alcoholic beverages and motor vehicles and consumers of these goods are heavily penalized.
  • Absence of civic consciousness.

Classification based on rates of tax or tax structure

Taxes are classified according to the relationship between amount paid as tax and income of the tax payer.

  • Regressive tax: takes a higher proportion of low income earners as compared to high income earners
  • Proportional tax: tax payers pay a fixed percentage of their income as tax.
  • Digressive tax: combines progressive and proportional tax systems. The tax rate keeps rising up to a maximum limit.
  • Progressive tax: amount paid increases proportionally

Merits of Progressive Tax

  • Helps in reduction of income inequalities. The higher income earners pay relatively more tax.
  • Reduced collection of tax as the revenue yielded is high but collection cost remains the same.
  • Motivation to work if rates are high as consumers will work harder to maintain their living standards.
  • Enhances distribution of resources as the rich are taxed more which reduces the gap between the rich and poor. The revenue raised from high income earners is used to improve welfare of poor.
  • Economical because the administrative tax do not rise with increase in tax rates.
  • Easily elastic can be helpful in curbing inflation.

Demerits of Progressive Tax

  • Discourages savings as those who work hard and earn more income are taxed heavily. Their savings are also taxed at increasing rates.
  • Encourages tax evasion as high incomes attracts high taxes. People will try to conceal some of their incomes.
  • Oppressive as the tax impair savings and thus hurt the levels of investment
  • Makes some assumption i.e. progressive taxes assumes that persons earning the same income derive the same benefits from that income and this is not always true.
  • Deterrent to work as high tax rate may deter people from working harder e.g. a progressive tax on personal income would make an individual to opt for leisure instead of working overtime to get extra income.
  • Inconvenient because taxation inconveniences tax-payer who has to comply with complicated formalities relating to sources of income as well as expenses incurred while generating it.
  • Deterrent to investment as heavy taxation deter entrepreneurs from investing in highly risky but profitable areas

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