Direct Tax

What Is a Direct Tax?

A direct tax is a tax that a person or organization pays directly to the entity that imposed it. An individual taxpayer, for example, pays direct taxes to the government for various purposes, including income tax, real property tax, personal property tax, or taxes on assets.

Understanding a Direct Tax

Direct taxes in the United States are largely based on the ability-to-pay principle. This economic principle states that those who have more resources or earn a higher income should bear a greater tax burden. Some critics see that as a disincentive for individuals to work hard and earn more money because the more a person makes, the more taxes they pay.

Direct taxes cannot be passed on to a different person or entity. The individual or organization upon which the tax is levied is responsible for paying it.

A direct tax is the opposite of an indirect tax, wherein 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 kinds of taxes are important revenue sources for governments.

Examples of indirect taxes include excise duties on fuel, liquor, and cigarettes as well as a value-added tax (VAT), also referred to as a consumption tax.

The History of Direct Taxes

The modern distinction between direct taxes and indirect taxes came about with the ratification of the 16th Amendment to the U.S. Constitution in 1913. Before the 16th Amendment, tax law in the United States was written so that direct taxes had to be directly apportioned to a state's population. A state with a population that is 75% of 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 a personal income tax, due to apportionment requirements. However, the advent of the 16th Amendment changed the tax code and allowed for the levying of numerous direct and indirect taxes.

Examples of Direct Taxes

Corporate taxes are a good example of direct taxes. If, for example, a manufacturing company reports $1 million in revenue, $500,000 in the cost of goods sold (COGS), and $100,000 in 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).

An individual's federal income tax is another example of a direct tax. If a person makes $100,000 in a year, for example, and owes the government $20,000 in taxes, that $20,000 would be a direct tax.

Other Types of Direct Taxes

There are a number of other direct taxes that are common in the United States, such as the property taxes that homeowners are required to pay. Those are typically collected by local governments and based on the assessed value of the property. Other types of direct taxes in the U.S. and elsewhere include use taxes (such as vehicle licensing and registration fees), estate taxes, gift taxes, and so-called sin taxes.