Difference Between Direct and Indirect Taxes Explained for Businesses and Consumers

Taxation is one of the topics that can cause headaches to individuals and businesses; therefore, understanding direct and indirect taxes is crucial. Common opinion is that taxation is a source of public funds, but in essence, it is more than that. It is an instrument or mechanism for redistributing wealth, shaping consumer behaviour, and addressing social inequalities.

Thus, for businesses, especially those operating in multiple jurisdictions and markets, it is vital to know the basics of each group of taxes and the types of taxes that fall under those groups. Non-compliance with tax rules always leads to penalties and interest, which can be expensive and risky for companies and could ultimately result in company closure.

Direct Taxes: Paid by Individuals and Businesses

Direct taxes are imposed directly on income or wealth and paid by individuals and businesses directly to the government. The most notable examples of direct taxes for individuals are personal income tax, property tax, inheritance tax, and, in some cases, capital gains tax. For businesses, direct taxes include corporate income tax (CIT) and capital gains tax.

The main characteristics of direct taxes are that they are progressive, cannot be shifted to others, and are typically based on the origin of income. What is meant by stating that direct taxes are progressive is that higher earners pay a higher percentage of their income. 

Since direct taxes are imposed directly on taxable persons and paid directly to the government by the persons, either natural or legal, on whom they are imposed, they are non-transferable. For example, in the US, the federal income tax is a type of direct tax that cannot be transferred or shifted to others. 

Origin-based taxes mean taxes are charged and paid in the country where the income is earned, assets are located, or the taxable person has residency.

For example, a typical direct tax scenario is when an Irish cloud-based provider of services in Ireland and the EU is subject to Irish corporate income tax on its taxable income. For direct tax purposes, the origin of the consumer is irrelevant, and the only relevant fact is where the income is earned, which in this case is Ireland. Therefore, the company pays its taxes directly to the Irish Tax and Customs Agency.

If a French-based software engineer works for this Irish company, that employee must pay personal income tax in France since that is the place of residency and where the income is earned.

Indirect Taxes: Passed on to Consumers

While direct taxes are imposed on individuals and businesses, indirect taxes are levied on goods and services rather than income or profit. Indirect taxes are typically collected and remitted by intermediaries, such as e-commerce operators, retailers, or service providers, and ultimately passed to final consumers.

The characteristics of indirect taxes, such as VAT, GST, consumption, or sales tax, are regressive, passed on to consumers, and are typically destination-based. In addition to the mentioned types of indirect taxes, excise and customs duties also belong to this group of taxes.

As indirect taxes do not vary according to the buyer's income, lower-income households spend a larger portion of their earnings on them, which makes them regressive. Indirect taxes are levied by suppliers or manufacturers, who pass them on to other suppliers and manufacturers, who ultimately pass them on to the consumer, who pays the final price for goods or services. Finally, indirect taxes are collected and remitted in the country where the goods or services are consumed or supplied, based on the destination principle.

Unlike direct taxes, if a consumer from Spain buys a tablet online, the product's price already includes VAT or GST, which the online marketplace collects and remits to the Tax Authority. Although the consumer is not directly responsible for remitting the tax, the VAT or GST is included in the purchase price and is later passed by the seller to the Tax Authority. The system is set so that while the tax burden falls on the final consumer, the collection and remittance process is handled by the seller liable for VAT or GST.

The Future of Taxation in a Digital Economy

Looking at the current trends and the future, the rapid evolution of the digital economy is one of the main drivers for reshaping how countries across the globe approach taxation. Online services, digital platforms, cryptocurrencies, and other prominent characteristics of the digital economy pose unique challenges for traditional tax systems.

The transition to a more digital business environment is apparent, leaving governments at risk of inaccurately tracking and taxing transactions, primarily digital transactions relating to the cross-border supply of goods or services. Therefore, the reforms of national and international regulatory frameworks are one of the main steps to address issues such as tax base erosion and profit shifting, which contribute significantly to the ineffectiveness of the current taxation systems. 

Some steps in this direction are underway with the Digital Services Tax (DST) or OECD's Global Anti-Base Erosion (GloBE) Model Rules and EU DAC7, DAC8, DAC9, and VAT in the Digital Age (VIDA) legislation. However, some regulations are still being drafted and debated, leaving much space for further improvements. The continuous work could result in new types of taxes or new tax collection systems.

In addition to the tax reforms, technology will continue transforming how taxes are monitored and administered. Blockchain and AI are emerging as leading technologies integrated into tax systems to improve transparency and ensure compliance. Furthermore, the implementation of e-invoices, electronic tax filing systems, and new reporting mechanisms that allow near real-time data analysis will certainly increase globally.

Conclusion

While direct taxes are often considered for their ability to tailor contributions according to income levels, indirect taxes remain a crucial revenue source for governments, especially in developing economies where administrative capacities are typically limited.

As policymakers navigate changes in the economy and business models, predominantly affected by the digital economy, a well-informed understanding of the roles and impacts of direct and indirect taxes will be crucial for businesses to reach compliance and remain competitive in a globalized market.

Source: US Internal Revenue Service, Reuters - Direct vs. indirect tax: the differences, Reuters  - What exactly is indirect tax?, Forbes, European Parliament - Direct taxation, European Parliament - Indirect taxation, VATabout - Digital Economy Taxation: VAT/GST on Digital Services vs. DST Explained, VATabout - EU DAC 9 & OECD Pillar Two: Key Tax Reforms & Compliance Insights