Direct taxes are taxes that are paid directly to the collection agency, such as the IRS or a state tax board. Direct taxes can include taxes such as estate, capital gains, income and property taxes as well as entitlement taxes for social programs like Social Security, Medicare or Medicaid. They differ from indirect taxes in that there isn't a third party passing the tax on (as is the case in sales taxes, for example).
That makes them simpler than indirect taxes, since fewer entities are involved and the tax monies travel to fewer points before reaching their destination. Direct taxation provides tangible benefits, but also some drawbacks as well.
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Transparency in Taxes
Direct taxes are transparent taxes. What this means is that the person paying the tax knows exactly how much is taken and to which specific agency it goes. Also, the taxing agency is more accountable to the people whom it taxes, since the taxpayer doesn't have to follow a trail through any third parties.
In addition, it allows the taxpayer to address discrepancies more readily, since he can spot them via his own records and point them out to the collecting agency should a situation arise.
Understanding Progressive Taxation
Direct taxes tend to be more progressive, in that the amounts are scaled to reflect a person's income. Someone working at the poverty level, for example, pays a smaller percentage of his income in taxes than someone who is a millionaire. However, indirect taxes such as sales taxes charge everyone the same amount, which eats up a greater percentage of a poor person's income than a rich person's income.
This is especially true in the case of essentials such as groceries or gasoline, which everybody needs to function in society. Because certain commodities are required by everyone to live, indirect taxes will affect a person who earns less income more than it would someone who earns much more, even though both are paying the same amount for the same tax.
Expense of Direct Taxes
A prominent disadvantage of direct taxes is that they cost more to administer than indirect taxes. With an indirect tax, the government need only charge the third party, such as a business in the case of sales taxes. A direct income tax, on the other hand, often means charging an entire populace, instead of just a percentage of them. That translates to more man hours required to collect the tax, more paperwork to keep track of the taxes collected and more space (both computer and practical) to house it.
Direct Tax Disincentives
Direct taxes also tend to discourage taxpayers from saving and investing. When taxes are paid directly, the consumer has no reason not to use the remainder of his money for purchases. Indirect taxes, on the other hand, may be attached to consumer goods, and the higher price may encourage consumers to postpone their purchase and save their money. Governments can use this to encourage its citizens to adopt certain practices, and in the process, help keep the nation's economy healthy.
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