Types of Taxation

Direct and Indirect taxes

A Direct Tax (on individuals) is a tax whose ultimate burden is borne by the same person on
whom it is levied. It may be based on income or property of a person. According to Dr.
Dalton, “a direct tax is really paid by the person on whom it is legally imposed. Thus, a direct
tax is one which cannot be shifted or passed on”. For example: income tax, property tax,
wealth tax, gift tax, corporation tax, etc. Merits of direct taxes: equitable (reducing
inequalities), promotes certainty, economical, elastic in nature, simple, etc. Demerits of direct
taxes: no diversity, tax evasion, unpopular, discouraged production, etc.
An Indirect Tax (on corporations) is that tax, which is initially paid by one individual, but
the burden of which is passed over to some other individual who ultimately bears it. It is
levied on the expenditure of a person. According to Dr. Dalton, “an indirect tax is imposed on
one person, but paid partly or wholly, owing to a consequential change in the terms of some
contract or bargain between them. Thus, an indirect tax is conceived as one which can be
shifted or passes on”. For example: excise duty, custom duty, sales tax, GST, entertainment
tax, etc. Merits: wide coverage, diversity, less evasion, useful to check consumption of
harmful goods, etc. Demerits: uncertain revenue, regressive in nature, uneconomical, feeds
inflation, etc.
Proportional, Progressive and Regressive Taxes
Proportional Tax
A proportional tax is one whose percentage rate remains the same as the tax base increases.
As a result, the amount of tax paid is proportional to the tax base. If the tax rate is constant at
30%, every person shall have to pay income tax at this rate as his/her income increases. For
example: a person with an income of Rs.1 lakh pays Rs.30,000 as the tax at the rate of 30%.
The person with double income of Rs. 2 lakhs pay double the amount if the tax at Rs.60,000.
Thus, here, as the income increases, the amount of tac also increases in the same proportion.
The resultant tax curve (T) is horizontal in nature and parallel to the X-axis. A proportional
tax applies the same tax rate to all individuals regardless of income. Proportional tax, also
referred to as a flat tax, affects low, middle, and high-income earners relatively equally. They
all pay the same tax rate, regardless of income. For Example: Tax Deduction at Source
(TDS).
Progressive Tax A progressive tax is one whose percentage rate increases as the tax base
increases. In other words, as the income of a person increases, the tax rate also increases
gradually and vice-versa. A progressive tax is ‘graduated’ so that a person with a higher
income pays a greater percentage in tax than a person with a lower income. The resultant tax
curve (T) raises (upward sloping) from left to right, as the tax rate increases with the rise in
income. For Example: Income Tax. 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. A progressive tax has more of a financial impact on higher-income individuals
than on low-income earners.
average rate. Therefore, when the average and marginal rates of taxation vary from each
other, it is necessary to carefully delineate the two in order to ascertain properly the effect of
the tax on individual behaviour.
The table above shows that as the tax base (slab of income) increases, the tax rate also
increases by an equal percentage. The first tax slab of Rs.1 lakh is totally exempted from tax.
Now with every increase by Rs.1 lakh, the tax rate increases by 5% beginning with a
minimum tax rate of 10%. The tax takes a larger percentage of income from people in higher
income slabs than those in lower slabs. A person in Rs.1 lakh to Rs.2 lakh income slab pays
Rs.10,000 as tax and a person in Rs.2 lakhs to Rs.3 lakhs pays Rs.25,000 (=Rs.10,000 +
Rs.15,000) as tax and so on. When a progressive tax rate structure is used, the ATR increases
with the size of the base. The larger the tax base, the larger the ATR applied. The tax bracket
gives the increment of annual income associated with each MTR. For progressive taxation,
the marginal rate of taxation eventually exceeds the average rate of taxation as the MTR
increases. For progressive taxation, the marginal rate of taxation eventually exceeds the
average rate of taxation as the MTR increases. The dichotomy between the two rates is
important, because the MTR is more crucial in determining behaviour changes that can cause
losses in efficiency than is the the average rate. Therefore, when the average and marginal
rates of taxation vary from each other, it is necessary to carefully delineate the two in order to
ascertain properly the effect of the tax on individual behaviour.
Impact and Incidence of Taxes:
The problem of incidence of taxation is related to the important question: who ultimately pays a
tax? Or, who bears the money burden of a tax? According to prof. Seligman, “impact is the initial
phenomenon, shifting is the intermediate process and incidence is the ultimate result.”

a) Impact of a tax is its first point of contact with the tax payer. It is upon those who bear the first
responsibility of paying it to the authorities, that is, those who have the statutory responsibly of
paying it to the government. Since it can be shifted (or passed on), it refers the immediate burden of
tax. For example: the government imposes an excise duty on tea. The tea company which grows,
blends and packs the tea has to pay the tax to the government in the first instance. This will be called
impact of tax.

b) Incidence of a tax is defined as its final resting place. It is to be seen and judged in terms of the
money “burden” of the tax. Since, it cannot be shifted (or passed on) further, it refers to as the
ultimate burden of tax. For example: if the tea manufacturer includes the tax in the price of tea and
transfer it to the wholesaler, who, in turn, transfers it to the retailer, and the retailer, in turn,
transfers it to the ultimate consumer. This process will be called tax-shifting. The incidence of the tax
is on the consumer, who ultimately bears the money burden of the tax. c) The incidence of a tax
involves the process of transfer from the person on whom the tax is imposed initially, to the ultimate
tax payer who bears the money burden of the tax. The process of transfer of a tax is known as the
shifting of the tax. The term shifting refers to the transfer of some or all of the burden of the tax
from the one on whom tax is imposed to another person, who ultimately pays the tax. It is the
process in between impact and incidence of taxation.

Types of Shifting of Taxes:

a) Forward Shifting - A forward-shifted tax is a tax imposed on producers but passed on to

consumers. The amount of a tax shifted forward depends on the price elasticity of demand for the
taxed good. Here, tax is shifted from the seller to the purchaser. Forward shifting takes place if the
burden falls entirely on the user, rather than the supplier, of the commodity or service in question—
e.g., an excise tax on luxuries that increases their price to the purchaser and not manufacturer.

b) Backward Shifting - A backward-shifted tax is a tax borne by firms and input suppliers. The
amount of backward shifting to input suppliers depends on their responsiveness to changes in input
prices. Here, tax is shifted from purchaser to the seller and from seller to the Factors of Production
(or their owners). Backward shifting occurs when the price of the article taxed remains the same but
the cost of the tax is borne by those engaged in producing it—e.g., through lower wages and
salaries, lower prices for raw materials, or a lower return on borrowed capital. For Example:
Consider 2 taxes that are imposed on firms, the employer-paid portion of the social security tax and
the corporation income tax. As a result of either tax, wages might fall or prices might rise. If wages
fall, we say that tax has been shifted backward (to labour): if wages fall by the full amount of tax,
burden has been fully shifted, and if wages fall by less than the amount of tax, burden is partially
shifted. If prices rise, we say that the tax has been shifted forward (to consumers).

c) Combination of both - A combination of both may take place when a producer of taxed
commodity is able to transfer money burden of a tax through a partial rise in price and through a
partial reduction in remuneration of factors of production. But generally shifting takes by forward
shifting.
d) Single-Point and Multi-Point Shifting - Shifting may be single-point or multi-point shifting. When a
tax is shifted directly from manufacturer or producer to the consumer, it is termed as single-point
shifting. On the other hand, when the burden of a tax is shifted from one point to several points, it is
known as multipoint shifting. For example, when the government imposes an excise duty on a good,
it may be paid in the first instance by the producer. But the producer may shift the burden to the
wholesaler who, in turn, may shift it to the retailers, who may finally pass it to the consumer. This is
an example of multi-point shifting.