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Know What are Direct Taxes and Why are They Called Progressive?

Nov 30, 2018 | 1 year ago | Read Time: 5 minutes | By iKnowledge Team

Direct taxes are those that an individual or corporation must pay on the income that they earn. Direct taxes increase as income increases, which makes them progressive.

The Government has many different sources of earning funds. The biggest revenue generator for the Government is tax. There are different types of tax in India that both the central and state Government levy on the citizens to ensure smooth functioning of the country. There are different taxes that one must pay, but broadly, the Indian tax system can be categorized into:

  1. Direct Tax
  2. Indirect Tax

What is direct tax?

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Direct tax is tax which is levied on income earned by a person, an institution, a corporation etc. It is called direct because the quantum of tax depends on the level of income earned.

It is directly charged to the person who earns the income. For example, suppose A earns Rs. 5 lacs during a financial year from the company he works with, he will have to pay tax on Rs 5 lacs, less any deductions for investments, insurance, medical costs and other possible deductions that are made available by the government under the Income Tax Act of 1961.

Direct tax is charged on specific sources of income at different rates. Some taxes such as income tax are charged at slab rates, where income up to a level is taxed at a rate. The rate of tax under the slab system keeps increasing for higher levels of income.

Some examples of direct taxes are:

  1. Income tax
    1. Income taxed at slabs for individuals, Hindu Undivided Families (HUF)
    2. Corporate tax
    3. Minimum Alternate Tax
    4. Alternate Minimum Tax
  2. Capital Gains tax: This is a tax paid on sale of capital assets, such as equity shares, jewellery, gold, paintings etc. The tax rate depends on the period for which the asset is held.
  3. Wealth tax (abolished by the Government from 2016): This tax listed a number of assets which were considered as wealth, and tax was charged at 1% on wealth above Rs. 15 lakhs.
  4. Securities Transaction Tax: This tax is charged on transactions in equity shares listed on a registered stock exchange.
  5. Dividend Distribution Tax: This tax is paid by companies on dividend that pay out to shareholders.

From the types of tax, it is evident that direct taxes are charged based on different types of incomes earned by a specific person. In case income is not earned, direct tax is not charged.

Direct taxes are also used to influence consumer behavior in terms of investments by providing deductions. For example, Section 80C of the Income Tax Act provides a deduction on investment in life insurance. This gives an impetus to people to invest in plans like Aegon Life’s iInvest plan which is a unit linked insurance plan or ULIP.

In a standard ULIP, a portion of the premium is allocated towards insurance, and the rest is invested in the market. Aegon Life’s iInvest plan invests 100% of the premium in the market, thus providing greater returns. The plan offers 6 different schemes to invest the premium in and provides flexibility to switch investments depending on investment goals. The plan pays the higher of sum assured, 105% of the premiums paid, or the maturity value of fund on maturity date of the policy, thus providing financial security to a family.

What are indirect taxes?

Indirect taxes are levied on a product or service regardless of the person who is consuming it. For example, till 2017, excise duty was charged on most products manufactured, such as biscuits, toothbrushes, machines, clothes, and a whole range of products. Service tax was charged on services by different organizations and individuals. VAT, Sales Tax, Octroi are some of the taxes State Governments used to levy. Since 2017, a unified tax regime called Goods and Services Tax is charged on products and services.

These taxes do not distinguish between the people who are consuming the product or service. Taxes on products are included in their final price and thus are paid by both the rich and the poor.

Why are direct taxes progressive?

The purpose of taxation is to raise resources for the Government. The Government then allocates these resources into different programs and at providing different facilities to the citizens of the country. For example, funds raised as direct taxes are used by the Government to build and maintain roads, hospitals, schools, colleges, create and maintain public infrastructure such as parks, recreation centres, provide facilities to poor people. These are only some of the examples of where Government money is used.

To run a country as large as India, with a huge population, it requires a huge amount of resources. With competing interests for funds, it is in the Government’s interest to raise as much funds as it can so it can meet the development objectives of the country.

However, it is not possible for every citizen to contribute equally in this fund-raising exercise. It is also not equitable for the Government to tax someone earning Rs. 5 lakhs the same way as someone earning Rs. 200 crores. It is for this reason that there are different slabs pertaining to income tax, so that those who do not earn a level of income is not responsible for contributing to the Government income.

 As per the existing income tax regime, individuals and Hindu Undivided Families who do not earn up to Rs. 2.5 lakh rupees incur 0% income tax, or they are not charged income tax. In Budget 2020, Nirmala Sitharaman announced a new slab system which would coexist with the old slab structure in the latest direct tax system. Under the latest slab system, individual taxpayers with income less than Rs. 5 lakhs are not liable to pay income tax.

As per this new system of direct taxation, individual taxpayers can choose whether they want to file their taxes under the previous slab system or the new tax regime.

Following the new regime for filing income tax returns would allow individuals to significantly reduce their tax liabilities; however, that choice would be accompanied by abolishment of nearly 70 tax exemptions and deductions available under the existing tax regime. Individuals who will choose to file their income tax as per the old regime will still be able to enjoy all the tax exemptions.

The following table shows highlights the difference between the existing tax regime and the new slab system.

Income Slab (in Rs.) Tax rates under the old regime Tax rates under the new regime
Up to Rs. 2,50,000 Nil Nil
Rs. 2,50,001 to Rs. 5,00,000 5% Nil
Rs. 5,00,001 to Rs. 7,50,000 20% 10%
Rs. 7,50,001 to Rs. 10,00,000 20% 15%
Rs. 10,00,001 to Rs. 12,50,000 30% 20%
Rs. 12,50,001 to Rs. 15,00,000 30% 25%
Rs. 15,00,000 and above 30% 30%

With a slab system, the people at the bottom most rung of society, who do not earn enough are not responsible for paying income tax. This leaves them with their entire income for their survival. It recognizes that people require money for sustenance and does not tax those who cannot earn. With different deductions and exemptions, investment behavior is directed into avenues that will provide incomes to the taxpayer after retirement. This is another way in which incomes are reduced, providing benefits to the people who don’t earn as much.

Direct taxes are progressive, because it is possible to help more people who do not earn as much, and at the same time, mobilize resources from those who earn well. This is what makes them progressive. Know about the different indian government schemes for women here. To know about Aegon Life’s life insurance products like term insurance and other products, visit our home page.

II/Oct 2018/4543


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