What is direct tax?

How does direct tax work?

A direct tax is paid directly by the taxpaying entity to the levying entity. The taxpaying entity could be an individual, partnership, corporation, trust or estate. The levying entity could be the federal government as the IRS, a state tax authority or even your local City Hall.

Direct tax has two hallmarks. First, the tax is paid by the person or other entity that incurs it. For example, most U.S. employees pay their own income tax. One exception is teenagers with part-time jobs whose earnings go on their parent’s return, but for the most part, if it’s your tax, you pay it.

The second characteristic of direct tax is that there is generally no way to avoid it. You cannot escape paying income or property taxes – they come as a natural part of earning money or owning property. There are ways to reduce the tax, such as through income tax credits or a property tax homestead exemption, but they cannot be legally evaded. If you try to avoid direct taxes, you can end up owing a lot of money in back taxes.

Types of direct tax

There are a few broad categories of direct taxes. All of them can exist at federal, state or local levels.

Income tax

This is the tax we think of most often when it comes to direct taxes. At the federal level, income tax is levied by the IRS. Most states also have some form of personal income tax, and some large cities even have a city income tax. Since it is a direct tax, every American with income must file their income taxes. The amount is based on a percentage of the income earned.

The U.S. income tax system is progressive, meaning that lower-income Americans will pay a lower percentage rate than high-earners. This makes it less straightforward than a flat tax system would be, but it offers relief for low-income taxpayers while still maintaining funding for important projects.

Corporate tax

In addition to the individual income tax, the IRS and most state taxation agencies also levy an income tax on corporations. Like the individual income tax, this is a tax based on value generated in the form of corporate income. As of 2024, the federal corporate tax rate is 21% of the corporation’s taxable income.

This is in addition to other taxes paid by corporations and other businesses, such as employment taxes, which vary based on the number and type of employees in the business.

Property tax

Property taxes are levied at the municipal level and generally are calculated as a percentage of the property’s value. The percentage will vary based on the revenue needs of the city. Various state subsidies, homestead exemptions and other income sources for the city may help to lower property taxes, but as a property owner, there is no way to completely avoid them.

Estate tax

An estate is a person’s net worth left behind after they die. Like most other forms of value, estates are also subject to a direct tax. According to the IRS, “Estate Tax is a tax on your right to transfer property at your death.” The estate tax is paid out of the value of the estate by the executor, or person who manages the estate.

While estate taxes can become quite exorbitant, they aren’t something most Americans have to worry about. If your net worth when you die will be less than around $13 million, you will owe no estate tax. However, for high-net-worth individuals who will owe estate tax, there are things you can do to lower that tax. A professional tax advisor should help you navigate that.

Direct tax vs. indirect tax

There is another kind of tax to be aware of, and that’s indirect tax. Sales taxes, excise taxes, gas taxes and customs taxes are all types of indirect taxes. Indirect taxes are generally based on consumption, and the tax ends up being passed along the supply chain until it is finally paid by the consumer.

Dennis Shirshikov, a professor of economics at the City University of New York, defined the difference between direct and indirect tax as the source of the tax. “Direct taxes, such as income tax, are levied on individuals and entities directly based on their earnings,” he explained.

“These taxes are progressive, aiming to distribute the tax burden more equitably among taxpayers based on their ability to pay. Indirect taxes, on the other hand, such as sales tax and excise taxes, are levied on the sale of goods and services,” said Shirshikov.

Sales and gas taxes are good examples of indirect taxes. The retailer or manufacturer is the one who actually “mails the check” for the tax to the government, but the money isn’t coming out of their pockets. The tax gets added to the sales price when the item (or gallon of gas) is sold, and it is truly paid by the buyer of the item. The retailer collects the tax at the time of sale and sends it to the government without actually adding any of their own money.

You pay indirect taxes every time you go shopping, buy gasoline or make a large purchase such as a car. There are also indirect taxes on items such as alcohol and cigarettes that make these items less desirable to buy.

Pros and cons of direct tax

Like any form of taxation, direct tax has both advantages and disadvantages.

Bottom line

Direct taxes are paid directly from the individual or company to the entity that levies the tax. The most common instance is income tax paid to the government, though there are other types as well. These include property tax, estate tax and corporate tax. Unlike indirect tax, direct tax cannot be passed on to another payer.