[Eco – 105] Taxation Structure in India – Direct Taxes/ Indirect Taxes etc – Explained

taxation

Good evening guys and girls,

As you know Economy as a subject has always been a traditional bottleneck for Civil Services aspirants. This is because most of us did not study it during our school days.

So in this series of articles, we will be taking up the numerous economic jargon, one by one and try to simplify them for you.

We aim to do the above by explaining various economic terms in a simple and a lucid manner. This will be especially beneficial for the students who are going to give their first attempt.

In this article we will learn about taxation system in India. We will learn about the direct taxes, indirect taxes in India.

Table of Contents

    1. Tax
    2. Taxation in India
    3. Constitutional provisions regarding Taxation in India
    4. Types of taxes
      1. Direct Taxes
      2. Indirect Taxes
    5. Types of Direct Taxes
      1. Income Tax
      2. Corporate Tax
      3. Minimum Alternative Tax (MAT)
      4. Dividend Distribution Tax (DDT)
      5. Securities and Transaction tax/Commodities Transaction Tax
      6. Commodity Transaction Tax
      7. Capital Gains Tax (CGT)
      8. Fringe Benefit tax (FBT)
      9. Wealth Tax
      10. Estate Duty
    6. Merits and Demerits of Direct tax
    7. Types of Indirect Tax
      1. Customs Duty
      2. Central Excise Duty
      3. Central Sales tax
      4. Service Tax
      5. GST
    8. Merits and Demerits of Direct tax
    9. Practice Questions

1.Tax

First let us understand what we mean by Tax?

In simple terms, tax is the money paid by the taxpayers to the government. Tax is compulsory payment and not voluntary payment or donation made by the taxpayers. It is compulsory as it is extracted by the government through legislation. If taxpayers fails to pay the taxes or evade taxes, it is punishable by law

Government performs various functions – such as maintenance of law and order/ defence, undertakes welfare and developmental activities, provides public goods and services. Now the government needs money to perform these functions and it gets it through Taxation.

Eg- Central Government provides income support to farmers (PM-KISAN), scholarships to the vulnerable sections etc. These are funded by the Taxpayers money  

Types of Taxes according to fairness

A tax can be

    1. Progresstive Tax
    2. Proportional Tax
    3. Regressive Tax
Progressive Tax

A tax that takes a larger percentage of income from high-income groups than from low-income groups.

For example – Income Tax rate India. (tax rate goes up as income level rises). Rich people pay a larger portion of their income as tax in comparison to poor people

 Proportional Tax

A tax that takes the same percentage of income from all income groups

For example – if the Government decides to have a single slab in Income tax rate (let us assume 30%). Then the percentage of income paid in taxes will be same for the low income group, middle income group and high income group.

Regressive Tax

A tax that takes a larger percentage of income from low-income groups than from high-income groups. 

For example – An indirect tax on Hair Oil (let us suppose – 18%). Lower income group pay high proportion of their income as tax while buying it than higher income group

2.Taxation in India

India has a well developed taxation structure. 

The tax system in India is mainly a three tier system which is based between the Central, State Governments and the local government organizations (such as Municipality and Panchayats).

Thus, Taxes in India are levied by 

    1. Central Government
    2. State Government
    3. Local authorities such as panchayats and Municipalities

3.Constitutional Provisions Pertaining to taxation in India

Art 265 states that no tax shall be levied or collected except by the authority of law. 

It means that whatever tax is being charged has to be backed by the law passed by parliament or state legislatures. In other words, no tax can be levied if it is not backed by legislation passed by either Parliament or state legislatures. Any tax levied by the government which is not backed by law or is beyond the powers of the legislating authority may be struck down as unconstitutional.  

Distribution of Taxation Power 

Article 246 (SEVENTH SCHEDULE) of the Indian Constitution, distributes legislative powers including taxation, between the Parliament and the State Legislature. 

Schedule VII provides for the three lists:

  1. List – I (It provides for areas on which only parliament is competent to make laws)
  1. List – II ( It provides for areas on which only state legislature can make laws)
  1. List – III (the areas on which both the Parliament and the State Legislature can make laws upon concurrently ) 

Separate heads of taxation  are provided under List- I & List – II of Seventh Schedule of the Constitution. However, there is no head of taxation in the Concurrent List (It means that Union and the States have no concurrent power of taxation)

Article 246(1) – Parliament has exclusive powers to make laws with respect to any of matters enumerated in List I in Seventh Schedule

Article 246(3) provides that State Government has exclusive powers to make laws for State with respect to any matter enumerated in List II of Seventh Schedule to Constitution(i.e. State List).

Art 248 mentions that the residual powers of Legislation are vested in the parliament. It means that Parliament has exclusive power to make any law with respect to any matter not enumerated in list II and III.  Such power shall include the power of making any law imposing a tax not mentioned in either of those lists.

Taxes within Union jurisdiction as specified in List I in the Seventh Schedule of the Indian Constitution

Some of the important ones are:

    • Income Tax other than agricultural income  
    • Duties of customs including export duties  
    • Corporation Tax
    • Estate duty in respect of property other than agricultural land  
    • Taxes other than stamp duties on transactions in stock exchanges and futures markets  
    • Taxes on the sale or purchase of newspapers and on advertisements published therein  
    • Taxes on sale or purchase of goods other than newspapers, where such sale or purchase takes place in the course of inter-State trade or commerce  
    • All residuary types of taxes not listed in any of the three lists of Seventh Schedule of Indian Constitution  
Taxes within State jurisdiction as specified in List II in the Seventh Schedule of the Indian Constitution

Some of the important ones are

    • Land Revenue
    • Taxes on Agricultural Income
    • Taxes on lands and buildings
    • Taxation on the Consumption of Sale of electricity
    • Tolls
    • Taxes on luxuries, including taxes on entertainments, amusements, betting and gambling  
    • Stamp Duty
    • Taxes on vehicles suitable for use on roads  
Taxes levied by local governments

The 73rd and 74th constitutional amendment act have provisions to levy taxes by panchayata and Municipalities respectively. A State may by law authorise a Panchayat (or Municipality) to levy, collect and appropriate taxes, duties, tolls etc.

4.Types of Taxes

There are two types of taxes

    1. Direct Tax
    2. Indirect tax
Direct Tax

Direct tax is imposed directly on the taxpayer. Also, it is paid directly to the government by the person on which it is imposed. Direct tax cannot be shifted by the taxpayer to someone else.

Thus, in case of Direct tax, the incidence of tax, and impact of tax is on the same person.

Examples of Direct Tax – Income tax, Corporate tax etc.

Indirect Tax

An indirect tax is a tax collected by an intermediary (such as a retail store) from the person who bears the ultimate economic burden of the tax (such as the customer). An indirect tax is one that can be shifted by the taxpayer to someone else. 

Example – Suppose a person X buys hair oil from a retail store Y. Now the Government imposes a GST of 18% on the Hair oil. The person buying the Hair oil (X in this case) pays this tax to the Retail store Y, which ultimately pays to the government.

Thus in case of Indirect tax, the incidence of tax and impact of tax do not lie on the same person

[Learning – Let us know in the comment box, who among the X and Y bears the incidence of tax and impact of tax in above example]

Direct Tax Indirect Tax
Incidence and impact of tax fall on the same person Incidence and Impact of tax fall on two different persons
It is levied on the income. Eg – Income tax, Corporate tax etc. It is levied on goods and services. Eg- GST etc.
It is progressive in nature- higher taxes are levied on persons earning higher income It is regressive in nature i.e. all persons (rich and poor) will bear the same taxes on goods and services, irrespective of their capability to pay.

Let us discuss some of the important Direct Taxes

5.Types of Direct Tax

We shall study the following direct taxes in this article

    1. Income Tax
    2. Corporate Tax
    3. Minimum Alternative Tax (MAT)
    4. Dividend Distribution Tax (DDT)
    5. Capital Gains Tax (CGT)
    6. Securities and Transaction tax/Commodities Transaction Tax
    7. Wealth Tax
    8. Estate Duty
    9. Fringe Benefit tax (FBT)

All the above taxes are imposed by Union Government

Example of Direct Tax which are imposed by States are:

    1. Land revenue
    2. Stamp Duty
    3. Property Tax
    4. Professional Tax (maximum ceiling – Rs. 2500)
    5. Agricultural Income tax
Income Tax 

According to Income Tax Act 1961, every person, who is an assessee and whose total income exceeds the maximum exemption limit, shall be chargeable to the income tax at the rate or rates prescribed in the Finance Act. Such income tax shall be paid on the total income of the previous year in the relevant assessment year.

It is a direct tax. It is progressive in nature.

Corporate Tax

Corporation tax is a direct tax imposed on the net income or profit of the companies. Companies, both public and privately registered in India under the Companies Act 1956, are liable to pay corporation tax. This tax is levied at a specific rate according to the provisions of the Income Tax Act, 1961.

Effective tax rate which companies pay in India comprises of Corporate Taxes, surcharges and cess.

In September 2019, the government announced to reduce the corporate tax rate from the existing 30-25 per cent (depending on the turnover thresholds) to 22 per cent (effective rate 25.17 per cent, including surcharge and cess) for all the domestic companies, subject to them not availing of a specified list of exemptions.

Minimum Alternate Tax (MAT)

Several Companies make huge profits during a year. However, they minimise paying taxes to the government by taking the advantage of various provisions of Income-tax Law (like exemptions, deductions, depreciation, etc.). Thus, companies reduce their tax liability or they do not not pay any tax at all. Due to increase in the number of zero tax paying companies, MAT was introduced from assessment year 1988-89. Later on, it was withdrawn by the Budget 1990 and then reintroduced by Budget 1996.

The objective of introduction of MAT is to bring into the tax net “zero tax companies” which in spite of having earned substantial book profits and having paid handsome dividends, do not pay any tax due to various tax concessions and incentives provided under the Income-tax Law.

MAT is levied on book profit.

In September 2019, the government reduced the MAT tax rate from 18.5 per cent to 15 per cent. 

Further, Any domestic company will have an option to pay income-tax at the rate of 22% subject to the condition that they will not avail any exemption/incentive. The effective tax rate for these companies shall be 25.17% inclusive of surcharge & cess. Also, such companies shall not be required to pay Minimum Alternate Tax. 

Dividend Distribution Tax (DDT)

Companies distribute dividends out of their profits to their shareholders. The tax which is levied on this dividend is called Dividend Distribution tax (DDT). It is levied in addition to income tax.

Currently, companies are required to pay Dividend Distribution Tax (DDT) on the dividend paid to its shareholders at the rate of 15% plus applicable surcharge and cess in addition to the tax payable by the company on its profits. 

Before Budget 2020-21 – Dividend Distribution Tax was levied at the hands of the company, meaning that company distributes dividend after deducting DDT from it. An individual taxpayer was required to pay tax on dividend at 10% only in case dividend received from Indian companies was more than Rs 10 lakhs and no tax was payable in case of dividends received from mutual funds.

After Budget 2020-21 – It has proposed to remove the DDT on dividends paid by the companies.  The dividend shall be taxed only in the hands of the recipients at their applicable rate. Further, all kinds of dividend income i.e. dividend income received from mutual funds and shares will now be taxable in the hands of taxpayers.

Securities and Transaction Tax [STT]

It is a tax levied at the time of purchase and sale of securities listed on stock exchanges in India. It is governed by the Securities Transaction Tax Act (STT Act).

This tax was introduced in Union Budget 2004 and came into effect from October 1, 2004. The aim behind the introduction of STT was curbing evasion of capital gains tax on profits earned by transacting in securities.

Commodity Transaction Tax

It is a tax levied on commodity trading in India. It is similar to Securities Transaction tax imposed on the sale and purchase of equities in the stock market.

Commodity Transaction tax was first mooted in the Budget 2008-09. However, due to opposition it was withdrawn.

In the Union Budget 2013-14, Commodity transaction tax was imposed on non-agricultural commodities futures contracts at 0.01 per cent of the contract price.  In 2018, CTT has been imposed on commodity options too.

Capital gains tax

Capital gains means profit or gains arising from the transfer of capital assets, such as selling of lands, building, vehicle, patents, trademark, jewellery etc. The owner of the capital assets has to pay capital gains tax on the capital gains made by selling capital assets.

Example – Mr. Kumar purchased a residential house in January, 2016 for Rs. 10,00,000. He sold the house in April, 2019 for Rs. 20,00,000. In this case residential house is a capital asset of Mr. Kumar and, hence, the gain of Rs. 10,00,000 arising on account of sale of residential house will be charged to tax under the head “Capital Gains”.

Capital Gains tax is of two types – Short term Capital Gains Tax and Long term capital Gains Tax. It depends on the duration of the capital asset held by the owner before selling it.  The tax rates for long-term capital gain and short-term capital gains are different.

Fringe Benefit Tax [FBT]

Fringe Benefits are the benefits in kind offered by the companies to their employees in addition to salaries paid to them.

Some of the examples of the Fringe Benefit Tax includes – telephone reimbursement, health insurance, subsidised cafeteria, access to gyms, free bus service, employee stock options etc. 

Fringe Benefit Tax is taxation of this benefits in kind which is provided by companies to their employees in addition to salaries paid to them.

It was introduced in the Budget 2005-06. It was abolished/discontinued in the Budget 2009-10.

Thus, the present situation is that Fringe Benefit tax has been abolished/removed/discontinued

Wealth Tax

It is a tax imposed on the richer section of society. It is levied on the total value of personal assets.

Before Budget 2016-17 – Wealth Tax @ 1% was charged on the net wealth exceeding Rs. 30 Lakh

After Budget 2016-17 – Wealth tax was abolished. It was replaced with an additional surcharge of 2 per cent on the super-rich (those with annual taxable income exceeding Rs 1 crore)

Thus, the current situation is that, Wealth Tax has been abolished

Estate Duty 

It is also known as inheritance tax. It was abolished in 1985.

6.Merits and Demerits of Direct Tax

Merits of Direct Tax
  1. Progressive Tax – related to ability to pay principle. So an important tool to reduce inequalities of income and wealth.
  2. Elasticity – A direct tax can be varied according to the needs of the government as well as according to the changes in the income of the people. For example – if the income of the people rises, the government may increase the direct tax and vice versa. 
  3. Certainty – A person liable to pay direct tax knows with certainty how much he has to pay and when he has to pay
  4. Equity  – It is generally progressive (based on ability to pay principle). Through it rich people can be made to pay more taxes than poor.Similarly, in case of necessity, low income group people can be given relaxation and the super rich can be made to pay more. Thus, an important tool to reduce income inequalities.
  5. It is an important tool in Fiscal policy of the government. For example – In case of high inflation, the government may increase the direct tax rate to reduce money in the hands of people so as to bring down the consumer demand. Similarly, to boost demand and improve employment, the government can reduce rates of direct tax.
Demerits of Direct tax
  1. Tax Evasion – People try to evade direct taxes by using different means (such as submitting false returns, etc). Thus it is also prone to excessive litigation. For example – Government has come out with Direct Tax Vivad se Vishwas Bill 2020, to provide for a mechanism for resolution of pending tax disputes related to income tax and corporation taxes
  2. Disincentive to work – Direct tax may be disincentive to work. In case of high direct tax rate, a large part of the income earned will be given to the government in the form of taxation. Thus It may disincentive people to work hard. It may reduce people’s willingness to work. Further, high direct tax may act as hurdle to Foreign Direct Investment to the country.
  3. Sectoral Imbalance – Certain sectors such as corporate sector is heavily taxed. Whereas, agriculture sector is tax free. Even rich farmers are exempted from personal income tax.

7.Indirect Tax

As we have seen, an indirect tax is a tax collected by an intermediary (such as a retail store) from the person who bears the ultimate economic burden of the tax (such as the customer). 

Let us Discuss some of the important types of Indirect Taxes

Types of Indirect Tax

Most important source of Indirect tax revenues for the Union

    1. Customs Duty
    2. Central Excise Duty
    3. Central Sales tax
    4. Service Tax
    5. GST

Most important source of Indirect tax revenue for the states

    1. Sales Tax
    2. Excise duty on alcoholic liquors
    3. Taxes on luxuries, entertainments, amusements, betting and gambling
    4. Electricity Tax
    5. Entry Tax

Note – With the implementation of GST, Several of the above taxes has been subsumed in it. We will be coming out a separate article on GST

Customs Duty

Customs Duty’ refers to the tax imposed on the goods when they are transported across the international borders.

In India, Customs Duty is levied on both export and import.

The idea is to prevent illegal imports and exports of goods, to provide protection to indigenous industries, and to keep the imports to the minimum in the interests of securing the exchange rate of Indian currency

Under the custom laws, the various types of duties are leviable:

  1. Basic Duty – duty levied on imported goods
  2. Additional Duty (Countervailing Duty) – It is equal to excise duty levied on a like product manufactured or produced in India.  
  3. Anti Dumping Duty  – Sometimes, foreign sellers abroad may export into India goods at prices below the amounts charged by them in their domestic markets in order to capture Indian markets to the detriment of Indian industry. This is known as dumping. In order to prevent dumping, the Central Government may levy additional duty equal to the margin of dumping on such articles which is called Anti Dumping Duty.
Central Excise Duty

It is levied on goods produced/manufactured in India and are meant for domestic consumption. After the introduction of GST (in July 2017), many of the  excise duty have been subsumed under it. It means excise duty, technically, does not exist in India except on a few items such as liquor and petroleum.

One must keep in mind that – Excise duty was levied on manufactured goods and levied at the time of removal of goods, while GST is levied on the supply of goods and services.

Sales Tax

It is a tax levied on the sale of goods. There are two kinds of Sales Tax 

    1. Central Sales Tax, imposed by the Centre 
    2. Sales Tax, imposed by each state
Central Sales Tax

It is a tax levied by the Central government  applicable on inter – state sales of goods (not on the sales of goods within the state or export/import). It is origin based tax. The proceeds of the taxes were given to the source/ exporting states from where goods went to other states. It has been subsumed under GST

Sales Tax

Each State follows its own Sales Tax Act and levies tax at various rates.  Thus Sales tax varied from state to state. 

2005 Onwards- States started implementing Value Added tax (applicable on each stage of sale)

It has been subsumed under GST

Service Tax

It is tax on the service providers in India (except J&K). It came into effect in 1994. It is levied and collected by the central government. It was brought through 88th Amendment Act 2003, which inserted Article 268A

It has been subsumed under Goods and Services tax

GST

It is a destination based tax on consumption of goods and services. It has come into force since 1st July 2017.

It has subsumed various taxes which were earlier levied by centre and states. 

Taxes levied by centre which has been subsumed under GST are 

  • Central Excise duty 
  • Duties of Excise (Medicinal and Toilet Preparations) 
  • Additional Duties of Excise (Goods of Special Importance) 
  • Additional Duties of Excise (Textiles and Textile Products)
  • Additional Duties of Customs (commonly known as CVD) 
  • Special Additional Duty of Customs (SAD) 
  • Service Tax 
  • Central Surcharges and Cesses so far as they relate to supply of goods and services

State taxes that would be subsumed under the GST are: 

  • State VAT 
  • Central Sales Tax 
  • Luxury Tax 
  • Entry Tax (all forms) 
  • EntertainmentandAmusementTax(except when levied by the local bodies) 
  • Taxes on advertisements 
  • Purchase Tax 
  • Taxes on lotteries, betting and gambling 
  • StateSurcharges and Cesses (so far as they relate to supply of goods and services)

We will read more about GST in the next article.

8.Merits and Demerits of Indirect Tax

Merits of Indirect Tax

  1. Wider Coverage/ Broad Based – Indirect taxes are broad based and have wider coverage in comparison to direct taxe. The effect of Indirect taxes are felt by more or less all the people in the society. It has to be paid (both by rich and poor) when they purchase tax imposed commodities. (In case of direct taxes, low income group may not be required to pay taxes)
  2. Sin Tax/Consumption Control – It can be used as a tool to discourage consumption of undesirable goods. For e.g. By Imposing taxes on luxury goods and making them more expensive, the government can divert resources from these sectors to sectors producing necessary goods. 
  3. Convenience -Government imposes indirect taxes on manufacturers. However, they are finally paid by consumers. They are convenient in the sense that tax payers (consumers) pay taxes in small amounts. Also  they are convenient to government as they collect these taxes in lumpsum from the manufacturers. 
  4. Elastic – It is elastic in nature. Since it has wider coverage, so any small increase in tax will bring in large revenue.

Demerits of Direct tax

  1. Regressive in Nature: Not equitable in nature. The rich and the poor have to pay the same rate of indirect taxes on commodities of mass consumption. This may further increase income disparities among the rich and the poor. They impose a heavier burden on the poor.
  2. Uncertain – Indirect taxes are often rather uncertain. Taxes on commodities with elastic demand are particularly uncertain, since quantity demanded will greatly affect as prices go up due to the imposition of tax. 
  3. Inflationary – As  Indirect  Taxes  increases  the  prices  of  the  commodity,  they  are  considered  as  Inflationary.  

 

That’s all we have in this post for you. Will see you guys in the next post.

UPSC Previous year Practice Questions

  1. Under which of the following circumstances may ‘capital gains’ arise?(UPSC – Prelims 2012)
    1. When there is an increase in sales of product
    2. When there is natural increase in the value of property owned
    3. When you purchase a painting and there is a growth in its value due to increase in its popularity

Select the correct answer from the code given below

  1. 1 only
  2. 2 and 3 only
  3. 2 only
  4. 1, 2 and 3
  1. Which of the following are direct tax in India? (UPSC – CDS 2013)
    1. Corporation Tax
    2. Tax on Income
    3. Wealth Tax
    4. Customs Duty
    5. Excise Duty

Select the correct answer from the code given below:

  1. 1, 2 and 3
  2. 1, 2 4 and 5
  3. 2 and 3
  4. 1, 3 4 and 5

 

  1. Which one of the following is not a feature of ‘Value Added Tax’? (UPSC – Prelims 2011)
  1. It is a multi point destination based system of taxation
  2. It is a tax levied on value addition at each stage of transaction in the production – distribution chain.
  3. It is a tax on final consumption of goods or services and must ultimately be borne by consumer
  4. It is basically subject of the central government and state government are merely facilitator for its successful implementation

 

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