Difference Between Direct and Indirect Taxes - Comparison

1. Allocation Effect ↓

The allocative effects of direct taxes are superior to those of indirect taxes. When a particular amount is raised through a direct tax like income tax, it would imply a lesser burden than the same amount raised through an indirect tax like excise duty.

An indirect tax involves excessive burden as it distorts the consumer's preference regarding goods due to price changes. Thus an indirect tax has an adverse effect on the allocation of resources than a direct tax.

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2. Distributive Effect ↓

Direct taxes are progressive and they help to reduce inequalities. But indirect taxes are regressive and they widen the gap of inequalities.

Hence, direct taxes are regarded to be superior to indirect taxes in effecting a more equitable distribution of income and wealth. But this is not always true.

Even indirect taxes can be made progressive by levying them on luxuries and exempting them on necessaries.

Both direct and indirect taxes are alternative methods of achieving any particular redistribution of income.

3. Administrative Costs ↓

The administrative costs of direct taxes are more than that of indirect taxes. Direct taxes are narrow based and has many exemptions. Indirect taxes can be conveniently collected and cost of collection is constant overtime. Indirect taxes are easier to administer than direct taxes.

From point of view of efficiency and productivity, indirect taxes are better. Indirect taxes are wrapped up in prices and hence they cannot be easily evaded. They are more productive as their cost of collection is the least.

Thus, from point of view of administrative costs, indirect taxes are relatively superior.

4. Built-in Flexibility and Stability ↓

Direct taxes are more flexible than indirect taxes. During a period of prosperity, direct taxes fetch more revenue as they are progressive. But indirect taxes are proportional and they do not fetch as much revenue as direct taxes.

Direct taxes help to reduce the inflationary pressure by taking away the excess purchasing power and hence they promote stability. But indirect taxes are inflationary.

Hence, from the point of stability, direct taxes are preferred to indirect taxes.

5. Growth Orientation ↓

Indirect taxes are more growth oriented than direct taxes. Direct taxes, being progressive, reduce savings. When savings and investments are discouraged, economic growth is adversely effected.

Indirect taxes discourage consumption and increase savings. Indirect taxes on luxuries reduce conspicuous consumption and channelise resources in to growth oriented programmes.

Conclusion ↓

Thus from the above points allocation, distribution and stability, direct taxes are superior. From the view of productivity and economic growth, indirect taxes are more superior. But the use of both direct and indirect taxes is indispensable in modern public finance.