Classification of Taxes: Direct vs Indirect Tax

Tax remains a major source of revenue to the government, so tax is imposed on almost all the products that we consume (in Nigeria, essential goods are excluded from tax - explained in the last paragraph) and services that we render. Tax is a compulsory levy imposed on business organizations and individuals. When a business makes a profit or an individual earns money over a period, it is expected of them to pay taxes to the government. Therefore, we may not be aware, but we all pay taxes directly or indirectly.

Generally, taxes can be classified in various ways, depending on the perspective through which the taxes are being received or paid. However, let's focus on the perspective of Tax Subject. There are two classes of tax: Direct tax and Indirect tax, they will be explained below.

a. Direct Tax:
This is a tax levied on the income or profits of the person who pays it, rather than on goods or services. This is termed direct tax because the taxpayer suffers the tax alone and may not be able to transfer the tax burden to others.

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Example of direct taxes are;
  1. Personal Income Tax (PIT)
  2. Companies Income Tax (CIT)
  3. Capital Gains Tax (CGT)
  4. Petroleum Profit Tax (PPT), etc.
b. Indirect tax:
This is a tax levied on goods and services, rather than on profits or income. Indirect tax could be specific (like VAT at the new rate of 7.5% in Nigeria), or it could be ad-valorem (in proportion to the estimated value of the goods or transaction concerned.) i.e a percentage of the goods sold/bought.

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Examples of indirect taxes are;
  1. Import and Export Duties
  2. Excise Duties
  3. Value Added Tax. etc.
Key Differences Between Direct Tax and Indirect Tax
Some of the key differences between direct and indirect tax are as follows:
  1. Direct tax is imposed on an individual and is paid by an individual whereas the taxes which are paid indirectly by the taxpayers are known as Indirect tax. A direct tax are paid on wealth and income but indirect tax is paid to the government when a individual buys and consumes an item.
  2. The liability of direct tax is solely rested on the shoulders of an individual and it cannot be passed on to any other person or group of persons whereas indirect taxes are passed on from the manufacturers to the consumers.
  3. Since the deciding factor is the income of the individual, direct tax creates fewer burdens. But indirect taxes create more burden as it is not related to income but depend on the purchase of goods and services.
  4. An individual can evade direct tax if there is a lack of proper administration of tax collection but indirect tax cannot be avoided unless you stop consuming things which is highly impossible.
  5. Direct tax is progressive in nature but indirect tax is regressive in nature.
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Summary:
  1. Taxes according to tax subject are classified into direct tax and indirect tax
  2. Direct taxes are taken from individual earnings or profit
  3. Indirect taxes are imposed on goods that consumers buy. 
  4. This is the tax you may not be aware of, because it looks so insignificant when you purchase an item.
  5. You cannot completely escape from paying tax.
Note: Essential goods exempted from tax (VAT) includes: book and educational materials, basic food items, medical and pharmaceutical products, baby products, etc. Goods that are exempted from tax are not the same across the world, every country has their tax law.

Co-written by Richard Okunola