The Tax System in India

A government needs money to provide public services, build infrastructure, and maintain law and order. To meet these expenses, it collects money from its citizens in the form of taxes. A tax is a compulsory payment made by individuals and businesses to the government. The tax system in India is carefully designed to ensure economic growth, fairness, and social welfare.

Canons of Taxation:

The characteristics or qualities which a good tax should possess are described as canons of taxation. It must be noted that canons refer to the qualities of an isolated tax and not to the tax system as a whole. A good tax system should have a proper combination of all kinds of taxes having different canons.

According to Adam Smith, there are four canons or maxims of taxation. They are as follows:

Canon of Ability

• The Government should impose tax in such a way that the people have to pay taxes according to their ability. In such case a rich person should pay more tax compared to a middle-class person or a poor person.

Canon of Certainty

• The Government must ensure that there is no uncertainty regarding the rate of tax or the time of payment. If the Government collects taxes arbitrarily, then these will adversely affect the efficiency of the people and their working ability too.

Canon of Convenience

• The method of tax collection and the timing of the tax payment should suit the convenience of the people. The Government should make convenient arrangement for all the tax payers to pay the taxes without difficulty.

Canon of Economy

• The Government has to spend money for collecting taxes, for example, salaries are given to the persons who are responsible for collecting taxes. The taxes, where collection costs are more are considered as bad taxes. Hence, according to Smith, the Government should impose only those taxes whose collection costs are very less and cheap.

Direct Tax

A direct tax is a tax levied on an individual’s income and wealth and is paid directly to the government. The burden of this tax cannot be shifted to others.

• It is progressive in nature, meaning it is levied according to the paying capacity of the person. In other words, higher-income groups are taxed more, while lower-income groups are taxed less, thereby ensuring equity.
• The plans and policies of direct taxes are recommended by the Central Board of Direct Taxes (CBDT), which functions under the Ministry of Finance, Government of India.

Merits of Direct Taxes

1. Equity:

Direct taxes are progressive in nature, meaning the tax rate increases with the tax base. For instance, income tax follows the principle of equity by charging the rich more than the poor.

2. Certainty:

They satisfy the canon of certainty. An income taxpayer knows in advance when, how, and at what rate the tax must be paid, leaving little scope for ambiguity.

3. Elasticity:

Direct taxes are income elastic. As income levels rise, government tax revenue automatically increases without the need for frequent rate revisions.

4. Economy:

The cost of collection is relatively low. Since taxpayers pay directly to the state, there is less administrative expenditure involved compared to indirect taxes.

5. Civic consciousness:

The taxpayers are always aware of the fact that a part of their income has been transferred to the government. They begin to show more interest in the affairs of the government they work like watchdogs.

6. Reducing inequalities:

Direct taxes are generally progressive in nature. Higher incomes are taxed at higher rates.

7. Simplicity:

Direct taxes are generally simple. They are normally understood clearly by ordinary taxpayers.

Demerits of Direct Taxes

1.Unpopularity:

Direct taxes are generally unpopular among the people. They are considered inconvenient and less flexible compared to indirect taxes.

2. Adverse Effect on Productivity:

Higher rates of direct taxes may discourage individuals from earning more, as increased income leads to higher taxation. This may reduce incentives for productivity and innovation.

3. Inconvenience:

Taxpayers often find it inconvenient to maintain detailed accounts, file returns, and pay taxes in lump sum, especially salaried and small business individuals.

4. Tax Evasion:

The heavy burden of direct taxes creates incentives for tax evasion. This leads to generation of black money, which is detrimental to economic stability and governance.

Indirect Tax

Indirect Tax is referred to as a tax charged on a person who purchases the goods and services and it is paid indirectly to the government. The burden of tax can be easily shifted to another person.  It is levied on all persons equally whether rich or poor.

There are several types of Indirect Taxes, such as:

• Excise Duty: Payable by the manufacturer who shifts the tax burden to retailers and wholesalers.
• Sales Tax: Paid by a shopkeeper or retailer, who then shifts the tax burden to customers by charging sales tax on goods and services.
• Custom Duty: Import duties levied on goods from outside the country, ultimately paid for by consumers and retailers.
• Entertainment Tax: Liability is on the cinema theatre owners, who transfer the burden to cinema goers.
• Service Tax:  Charged on services like telephone bill, insurance premium such as food bill in a restaurant etc.

Merits of Indirect Taxes

1. Wider Coverage: Indirect taxes reach a larger population, as they are levied on goods and services consumed by both rich and poor. For example, in India, nearly everyone pays GST or excise duties, whereas only about 2% of the population pays income tax.
2. Equitable: Equity is ensured when indirect taxes are levied at higher rates on luxury goods consumed by the rich. This way, the rich bear a relatively larger burden compared to the poor.
3. Economical: The cost of collection of indirect taxes is low because producers, traders, and retailers collect the tax from consumers at the point of sale and remit it to the government. They act as honorary tax collectors.
4. Checks Harmful Consumption: Indirect taxes are used as an instrument of public welfare. Higher taxes are imposed on harmful goods such as tobacco, liquor, and cigarettes. These “sin taxes” discourage consumption of such products.
5. Convenient: Indirect taxes are included in the price of goods and services. Consumers pay them automatically while purchasing, without the burden of filing returns or lump-sum payments. Hence, they are less noticeable and more acceptable.

Demerits of Indirect Taxes

1. Higher Cost of Collection: Unlike direct taxes, indirect taxes involve a larger administrative mechanism. The government spends significantly on monitoring producers, traders, and retailers to ensure compliance, which raises collection costs.
2. Inelastic: Indirect taxes are generally less elastic than direct taxes. Since they are often levied at fixed (proportional) rates, revenue does not rise automatically in proportion to income growth.
3. Regressive Nature: Indirect taxes are often considered regressive because both the rich and the poor pay the same tax on essential goods. A larger portion of income is spent by the poor on consumption, making their tax burden relatively higher.
4. Uncertainty in Revenue: Higher indirect taxes raise prices, which may reduce demand. This makes revenue unpredictable. As Dalton remarked, under indirect taxation, “2 + 2 is not 4, but 3 or even less than 3,” highlighting the uncertainty in revenue outcomes.
5. No Civic Consciousness: Since indirect taxes are embedded in the price of goods and services, consumers often remain unaware that they are paying tax. This fails to create civic responsibility or a sense of direct contribution to the state.