What is Tax and How is It Imposed?

While this term is known to most of us, tax is an important concept that each of us must know with clarity. Once you learn from basic to advanced concepts, you will be able to deal with the complexities related to taxation. Let us get started.

Table of Contents

• What is Tax?
• Understanding Tax with the Help of Example
• Types of Taxes
  • Direct Tax
  • Indirect Tax
• Tax Laws in India

What is Tax?

Tax is a compulsory charge that an individual or a business entity has to pay the government for the growth and development of economy. Through taxes, the revenue collected is used for building infrastructure and facilities for public welfare. Several types of taxes are collected both directly and indirectly from the public. Different taxation authorities are responsible for collecting these taxes. 

Understanding Tax With the Help of An Example

Imagine you are planning a birthday party for a friend:

Direct Taxes:

• Income Tax: As the party host, you earn a salary from your job. Before you receive your paycheck, a portion of your income is automatically deducted as income tax, a direct tax paid to the government based on your earnings. This tax contributes to public services like roads, schools, and hospitals.
• Gift Tax: If you plan to give your friend an expensive gift, exceeding a certain threshold, you might need to pay gift tax, another direct tax levied on the value of the gift. This tax aims to promote wealth redistribution and reduce income inequality.

Indirect Taxes:

• Venue Rental: Renting a party venue might involve paying a sales tax or VAT (Value Added Tax), an indirect tax embedded in the rental fee. This tax is ultimately borne by you, the consumer, but collected by the venue owner and deposited with the government.
• Food and Decorations: Buying decorations, party supplies, and food items will likely include various indirect taxes such as:
• Excise Duty: Specific taxes levied on certain goods like alcohol, tobacco, or processed foods, already incorporated into the price you pay.
• GST: Most goods and services, including groceries, balloons, and decorations, will have GST embedded in their cost. This tax applies at each stage of the supply chain, adding to the final price you pay.
• Transportation: Hiring transportation for party guests may involve fuel taxes or service taxes, ultimately contributing to the government's revenue.

Let us now learn about different types of taxes and how these are used for different social activities. 

Types of Taxes

There are several types of taxes as mentioned below:

1. Direct Tax

Direct tax is a type of tax that individuals or business entities pay directly to taxation authorities. Such tax cannot be levied on a different person or business entity. 

Types of Direct Taxes

Within direct taxes, there are several types of taxes including the following:

Income Tax

• Income tax is the most common direct tax, levied on an individual's or entity's taxable income earned during a financial year.
• Different tax rates will be applicable to different income brackets, with progressive taxation favoring lower-income earners.
• In India, income tax brackets and rates are revised annually in the budget.

Corporate Tax

• This is a tax levied on the profits of companies and corporations.
• The corporate tax rate can be flat or graduated, varying depending on the company's size, industry, and profitability.
• In India, the current corporate tax rate is 22% for domestic companies and 40% for foreign companies (excluding applicable surcharges and cesses).

Capital Gains Tax

• Capital gains tax is levied on the profits made from the sale of capital assets like stocks, property, or investments.
• The tax rate and calculation methods for capital gains can vary depending on the asset type and holding period.
• In India, short-term capital gains (held for less than one year) are taxed at income tax rates, while long-term capital gains (held for over one year) are taxed at lower rates with specific exemptions.

Wealth Tax

• This is a direct tax levied on the net wealth of individuals exceeding a certain threshold.
• Wealth tax is not currently levied in India but has been in the past and could be reintroduced in the future.
• In some countries, wealth tax is seen as a way to promote greater income equality and address wealth inequality.

Inheritance Tax and Estate Tax

• These taxes are levied on the value of assets inherited from a deceased person.
• Inheritance and estate tax systems vary widely across countries, with some having exemptions for spouses and close relatives.
• India does not currently have a federal inheritance or estate tax, but some states levy their own inheritance taxes.

Gift Tax

• This is a tax levied on the value of gifts received above a certain threshold.
• Gift tax rules and exemptions can vary based on the relationship between the giver and receiver.
• Gift tax in India is exempt to a specified limit on gifts received from certain close relatives like parents, spouses, and children.
  

2. Indirect Tax

Indirect tax is incorporated within the price of goods and services. This type of taxation is levied on consumers even though they might be collected at different stages of production or distribution. 

Types of Indirect Taxes

Sales Tax

It is a tax levied on the sale of goods and services to the final consumer. Specific rates and structures vary significantly between countries and even within different states or regions. It is further categorized into the following: 

• Retail Sales Tax: Levied on retail sales to consumers.
• Use Tax: Levied on the use of goods or services purchased outside the jurisdiction where the tax is imposed.
• Hotel Occupancy Tax: Levied on the cost of hotel stays.
• Restaurant Tax: Levied on the cost of meals at restaurants.

Value Added Tax (VAT)

A specific type of sales tax where the tax is levied at each stage of the production and distribution chain. Businesses only pay the difference between the tax they incur on their inputs and the tax they collect on their outputs. This helps avoid double taxation and ensures the tax burden is on the end-consumer. Value Added Tax can be further divided into the following:

• Standard VAT: The most common type of VAT, applied to a broad range of goods and services.
• Reduced VAT: Applied to certain essential goods and services at a lower rate than the standard VAT.
• Zero-rated VAT: Applied to some exempt goods and services, where businesses collect no VAT but can still reclaim VAT paid on their inputs.

Excise Duty

A type of indirect tax levied on specific goods or products, often at the manufacturing or import stage. Excise duties are commonly applied to goods considered harmful or luxury items, such as tobacco, alcohol, and petroleum products. It has the following subcategories:

• Specific Excise Duty: A fixed amount per unit of weight, volume, or other metric.
• Ad Valorem Excise Duty: A percentage of the value of the goods.
• Compound Excise Duty: A combination of both specific and ad valorem duty.

Custom Duty

A trade tax levied on the import or export of goods across international borders. Serves to regulate trade, protect domestic industries, and generate revenue. Custom duty has the following subcategories:

• Import Duty: Levied on imported goods.
• Export Duty: Levied on exported goods.
• Anti-dumping Duty: Imposed to counter unfair pricing practices by foreign exporters.
• Countervailing Duty: Imposed to offset subsidies granted by foreign governments to their exporters.

Tax Laws in India

• The Income Tax Act, 1961: This law is the charging statute of Income Tax in India. It provides guidelines for the levy, administration, collection, and recovery of Income Tax. The Act contains 298 sections, 23 chapters, and several important provisions which contain all the aspects of taxation in India. It came into force on 1st April 1962.
• The Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015: This is an Act of the Parliament of India. It aims to curb black money, or undisclosed foreign assets and income and imposes tax and penalty on such income. The Act was enacted to penalize persons with black money abroad and to curb the overseas diversion of Indian funds to evade taxes in India. It provides for the levy, administration, collection, and recovery of tax on undisclosed foreign income and assets.
• The Taxation and Other Laws (Relaxation of Certain Provisions) Ordinance, 2020: This act was brought into effect on March 31, 2020. It provides certain relaxations related to compliance, such as extension of time limit and waiver of penalty, to certain specified laws. This Ordinance was enacted because of the spread of the COVID-19 pandemic. It was brought into effect due to the relaxation of certain provisions including the extension of time limits in the taxation and other laws.