Taxation Direct and Indirect taxes - Essay Example

Taxation Direct vs. Indirect Taxes The Purpose of this essay is to provide a critical discussion of the differences between direct and indirect taxes. The format that this paper will utilize is to first provide some background on taxation, followed by providing a single example of a direct tax and a single example of an indirect tax. Building on the previous points a critical discussion will be given which highlights the positive and negative aspects of direct and indirect taxes. Furthermore this paper will draw on a variety of different sources to help strengthen arguments. Lastly, it is the case that this paper will be writing in the context of Great Britain however it may be the case that this paper will draw on examples from other nations in order to highlight the relative strengths and weakness of said taxation methods. The question of what are taxes can in many respects be tricky. In its very simplest form according to Garner (2009) taxes are a type of burden placed upon individuals, property or business entities in order to support the government. In this respect it is the case that the government at any particular level would take this money and in turn provide some sort of service that in general would benefit the whole of society. Since ‘Government’ can be a broad term one could reduce that term to a simple legislative authority. Furthermore it should be noted that taxes are not voluntary and typically the legislative authority has the ability to force payment from the people being institutions that are in fact being taxed. The reasoning behind why taxation exists falls into something called the four R’s which are Revenue (to pay for government functions), Redistribution (of wealth presumably from richer classes to poorer), Re-pricing (To discourage over consumption of some goods), and Representation (of government to meet the needs of its citizenry). There are a number of different terms for taxation and indeed taxation takes on many special sub categories. For example there are capital gains tax which according to Reynolds (1999) represents a special tax placed on capital gains which are profits recognized from the sale of assets purchased at a lower price such as properties, commodities etc. A second example would be a corporate tax which is a specialized tax placed directly on a corporation or other such business entity (Depending on the jurisdiction). A third example would be an inheritance tax which can be any sort of taxes levied after the death of an individual. Tariffs often form an important element of taxation as it represents a specialized tax levied on the importation of goods or the movement of goods through a nation’s borders (this may hold special significance in an increasingly globalized economy). A last example of a specialized tax is called a toll which is some sort of fee levied for the right to travel on a maintained road or waterway, in this regard the income received from such a tax would typically be used to maintain the condition of the passageway. What is important to keep in mind is that any particular jurisdiction may have any number of direct, indirect or specialized tax used in any combination to suit the needs of the local citizenry. In this regard taxation can be tailored to meet the specialized needs of a particular area. According to Smith (1776) it is the case that every state ought to contribute towards supporting the government in proportion to their respective abilities. One could translate this as meaning the proportion of the revenue which entities actually are able to gain as a result of protection provided by the state. It is the case that in most modern societies many different government entities are charged with the collection and enforcement of taxes. In the case of Great Britain this role has been taken up by Her Majesty’s Revenue and Customs, and in the American context this role has been taken up by the Internal Revenue Service. It may be the case that the mandate and abilities of these organization may be different it could be argued that they both fulfill similar roles. What are indirect taxes and direct taxes? According to the financial-dictionary (2010) indirect taxes are taxes paid by an entity other than the one in which it is levied. In this regard a retail sales tax is collected by the government through an intermediary (The business) but is ultimately paid by the consumer. Building on this point according to the financial-dictionary (2010) a direct tax quite simply is a tax paid by an individual or organization on which it is levied. I this regard a personal income tax is levied on a specific person who ultimately is responsible for paying the entirety of the tax his or herself, so in this regard the tax can not be shifted to some other entity. Now that indirect and direct taxes have been defined a discussion on the merits of each will be conducted. In the case of indirect taxes there are many forms that this taxation can take on which ultimately can be broken into two categories which are sales taxes and value added taxes. Under sales taxes there are a number of sub categories such as excise taxes, gross receipts taxes and simple sales taxes. In the case of excise taxes these are sometimes called special taxes or duty of excise and according to Sullivan & Sheffrin (2003 p. 118) they represent an inland tax placed upon the production or sale of a good. This differs in many respects from a traditional sales tax insofar as it is often placed on a number of specialty goods such as petroleum products, alcohol, tobacco, pharmaceuticals, etc. Rather than simply being a specific percentage of the price of goods it may be the case that an excise tax can be a flat rate such as two pounds for a pack of cigarettes regardless of the overall price of the cigarettes. In this circumstance some excise taxes could be considered a type of ‘sin tax’ that helps support the costs incurred by the government for people consuming the product such as the cost of respiratory care in a hospital associated with a lifetime of smoking. This type of tax may be tied in with import duties as in the case of petroleum products, oil may have to be imported into a nation and then an additional tax is placed upon it by the end consumer to either function as a mechanism for dissuading people from driving and/or paying for the additional costs of having more vehicles on the roads. In the British context according to HM Revenue and Customs (2010) alcohol, environmental taxes, gambling, and tobacco are just some of the items affected by excise taxes. Gross receipts are similar to a typical sales tax however it is in its simplest form a tax against the total revenues of a company that is imposed without regard to the source of the money. In this respect the responsibility of paying the tax falls upon the shoulders of the business and not directly by the consumer. Chamberlain & Fleenor (2006) had argued that one of the most obvious negative consequences of this action is the possibility of an item being taxed more than once as it passes from point of origin through a number of middlemen and ultimately into the hands of the consumer. Value added taxes are similar to a standard sales tax however according to the investor-glossary (2010) this tax is added purposely at each stage of a particular products manufacture and distribution, or in other words as more value is added to a product the more the taxes are increased. The typical example given comes in the case of wood, where a simple log gets taxed based on the price paid by a mill, this finished lumber gets taxed based on the cost of finishing, if this lumber is converted into a chair it gets taxed again etc. As mentioned earlier, direct taxes are any form of taxation paid directly to the government. These types of taxes generally fall into four categories which are income taxes, corporate taxes, property taxes and transfer taxes. While the manner in which income taxes are collected may be different from region to region the message is still the same, insofar in it broadest term it refers to any taxes levied directly on individuals or businesses. This type of taxation may be broken into three sub categories which are progressive, regressive and proportional. According to Sommerfeld et al. (1992) a progressive tax is any kind of tax that varies (typically increasing) as the taxable base in turn increases. In this case, people who have very little disposable income typically need to pay a smaller portion of their income than people with a higher portion of disposable income. Building on this previous point, Sommerfeld et al. (1992) identified that a proportional tax is any tax there the rate is fixed however the amount of what can be taxed is subject to increases. According to Webster’s Dictionary (2010) a regressive tax is more or less the exact opposite of a progressive tax where the tax rate decreases as the base increases. When referring to property taxes these vary from region to region however generally it is a tax rate levied on a property owned by an individual or business. In this regard according to Gifis (1984 p.471) this type of tax is generally imposed by municipalities upon property owners within their jurisdiction based on the value of their property and set to a pre determined rate. If for example a property tax rate of 3% were established for a given municipality and a property was determined to be worth £50,000 than the owner would be responsible for paying £1,500 a year. However it should be noted that this could be considered a variable tax as the value of properties can fluctuate based on a number of externalities. A transfer tax is simply the taxes associated with transferring property of some kind from one entity to another. While this may vary from region to region it is generally speaking a fee that ultimately resembles a capital gains tax insofar as it represents a taxation on some sort of profit made by an individual. As a final example there is a model for something called a flat tax rate which could also be considered a direct tax. Simon (1998) identified a flat tax system as a direct taxation system in which the rate remains constant. In terms of the similarities of the two taxation systems (Indirect and direct) the most obvious difference is that with an indirect tax people are taxed depending on how much they consume, but with a direct tax, people are taxed depending on how much they earn. In this regard a direct tax is levied directly by the government onto the people whereas only by choosing to purchase goods would a person engage in contributing to indirect taxes. Adam Smith (1776) had once postulated that a ‘good tax’ should have four distinct qualities. Firstly taxes levied should contribute to the government in proportion to the revenue collected. Secondly taxes should be certain and not arbitrary. Thirdly, it should be levied at a time that is convenient and lastly it should be designed to take out and keep out as little as possible from the pockets of taxpayers. In this regard both indirect taxes and direct taxes could meet these criteria. The real strengths of a direct taxation system is that it serves as a great benchmark for redistribution of wealth, for example if a person is known to earn in excess of a £1,000,000 a year and lives in a property that is worth several times this amount than it becomes clear that this person is probably living comfortably and can afford to pay a significant portion of their income to the government. So assuming taxes are collected at the moment a person gets paid then it could be argued that under Adam smiths criteria that it is taken when it is convenient for a person to pay, but one must go on the assumption that the taxes are not levied in an arbitrary fashion, and the matter of whether or not there exists a proportionality or whether or ‘as little as possible’ is taken would be a matter of personal opinion. It should be noted that if a direct tax is too high it can be the case that an individual earner can be disenfranchised by the government and choose to relocate to a nation with more favorable tax laws. One great example that stands out was presented by Sir Michael Caine in an interview with Lipworth (2009) the actor identified that his number one reason for leaving the United Kingdom in the 1970’s and emigrating to the United States was to escape the crushing taxes on top earners. From this perspective a fine line must be drawn in order to get the most out of the citizenry without disenfranchising them to the point where they simply do not pay or they flee the country. Maintaining a tax base should be a priority for any acting government. The primary benefit of having an indirect tax is that it is often perceived is being much fairer to lower income individuals. In this regard if a person earns below £10,000 a year for example, it is unlikely that they would be willing or able to pay a significant portion of their income out directly to the government as this would likely drive the person to an even higher degree of poverty, however by no having a significant amount of money levied on a lower income individual directly and by having them pay some of their money indirectly to the government by the goods that they purchase than a kind of balance is struck. One of the major drawbacks of collecting taxes through an intermediary would be the possibility of fraud committed by the business placed in charge of collecting the tax. For example if a pizza parlor sells 1,000 pizzas in a given month and collects tax on these pizzas yet they only declare that they have sold 500 pizzas to the government they have effectively stolen directly from the consumer, money that was earmarked for the government. In this regard it can be considered an ineffective means When considering Adam Smith’s criteria for a good tax there is no question that the time for the collection of taxes is convenient as it is the case that the tax is indeed typically levied at the point of sale. Typically the indirect tax is not an arbitrary as it is a predetermined amount that only fluctuates on items such as petroleum, alcohol and tobacco and in this regard these items have a set tax system. Thirdly it could be argued that the as an indirect tax is not typically a massive amount (17.5% in the UK) so in this regard it could be argued that its goal is to keep as much as possible in the pockets of taxpayers. However, the idea of proportionality is difficult to assess and would largely be a matter of personal opinion. There are a number of strengths and weaknesses to all taxation regimes. Furthermore it is the case that most nations do not have a simple taxation system that relies on only one type of taxation. In this regard much like a good diversified investment portfolio, it is a wise decision to utilize both direct and indirect taxes is some form or another. In general terms most people consider the benefits that come from taxation as being a good thing. Philosophically speaking there are a number of benefits to society that come from taxation such as social development however there is no question that many people disagree with the tax regimes that they live in from the perceived benefit that comes from living in a given society. References Chamberlain, A., Fleenor, P. (2006). Tax Pyramiding: The Economic Consequences of Gross Receipts Taxes. Tax Foundation: Special Report No.147. Financial-Dictionary (2010) Direct Taxes Defined. [online] Available at http://financial-dictionary.thefreedictionary.com/Indirect+taxes Accessed on March 19th 2010. Financial-Dictionary (2010) Indirect Taxes Defined. [online] Available at http://financial-dictionary.thefreedictionary.com/Indirect+taxes Accessed on March 19th 2010. Garner, B. ed. (2009) Black’s Law Dictionary 9th ed. West Group. London. HM Revenue & Customs (2010) Excise Duty. [online] Available at http://www.hmrc.gov.uk/briefs/excise-duty/index.htm Accessed on March 19th 2010. Gifis, S. (1984) Law Dictionary 2nd ed. Barrons. Hauppauge, NY. Investor-Glossary (2010) Value Added Tax: Defined. [online] Available at http://www.investorglossary.com/value-added-tax.htm Accessed on March 19th 2010. Lipworth, E. (2009) Back in the Picture: The Crusading Return of Michael Caine. The Daily Mai. [online] Available at http://www.dailymail.co.uk/home/moslive/article-1223821/Back-picture-The-crusading-return-Michael-Caine.html#ixzz0W7i0JsPv Accessed on March 19th 2010. Merriam-Webster (2010) Regressive: Defined [online] Available at http://www.merriam-webster.com/dictionary/regressive Accessed on March 19th 2010. Reynolds, A.(1999) Capital Gains Tax: Analysis of Reform for Australia. A study Commissioned by the Australian Stock Exchange Ltd. For the Review of business Taxation. [online] Available at http://www.asx.com.au/about/pdf/cgt.pdf Accessed on March 18th 2010. Simon, J. (1998) A Dictionary of Taxation, Edgar Elgar Publishing Limited: Northampton, MA Smith, Adam (1977) [1776]. An Inquiry into the Nature and Causes of the Wealth of Nations. University Of Chicago Press Sommerfeld, R., Madeo, S., Anderson, K., Jackson, B. (1992), Concepts of Taxation. Dryden Press. Fort Worth, TX Sullivan, A., Sheffrin, S. (2003). Economics: Principles in action. Pearson Prentice Hall. Upper Saddle River, NJ: Read More