Taxes

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.

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.

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 the economy. 

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 percent of the population in relation to another state would only be required to pay direct taxes equal to 75 percent 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, $500,000 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 had no debt, depreciation or amortization, and had a corporate tax rate of 35 percent, its direct tax would be $140,000, derived as: ($400,000 x 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.

Other Types of Direct Taxes

The corporate tax is another form of a direct tax. This is the tax 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 type of direct tax is the property tax, paid by the owner of a property. 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.