Taxation - Direct and Indirect Taxes for UPSC

Definitions and Core Concepts

India's Constitution allows the Union and the states to levy taxes within their respective domains. Taxes may be classified by who bears the burden and whether the rate rises with income. Direct taxes include personal income tax, corporate income tax, capital gains tax, securities transaction tax and the now-abolished wealth tax. They fall directly on individuals or firms and the incidence (final burden) is the same as the impact (initial liability). Because rates increase with the taxpayer's ability to pay, direct taxes are generally progressive and promote vertical equity.

Indirect taxes are levied on the manufacture, sale or consumption of goods and services. GST, customs duty and excise duty are examples. Here, the initial burden falls on the supplier, but the supplier shifts the tax through higher prices so that the final consumer bears the incidence. Since everyone pays the same rate regardless of income, indirect taxes tend to be regressive: lower-income households spend a larger share of their income on taxed goods. GST on essential items illustrates how a flat-rate tax can hurt poorer households.

Economists further classify taxes as proportional, where the rate stays constant across income levels, or progressive, where rates rise with income. India's personal income tax slab system is progressive, while corporate tax can be considered proportional. A regressive tax takes a decreasing proportion of income as income rises; many indirect taxes such as GST on food and fuel are regressive because the poor spend a higher share of their income on taxed goods.

Impact vs Incidence of Tax

The impact of a tax refers to the initial liability - who is legally obliged to pay it. The incidence refers to who ultimately bears the economic burden after the tax has been passed along through prices. For direct taxes, impact and incidence coincide because the taxpayer cannot shift the tax. For indirect taxes, the seller may shift the tax to consumers, so the incidence falls on buyers even though the legal impact lies on sellers. For example, when a sales tax is levied on a shopkeeper, the shopkeeper raises the price; thus the consumer bears the final burden.

Another important concept is tax buoyancy - the responsiveness of total tax revenues to changes in nominal GDP. In FY 2023-24 India's tax buoyancy was 2.12, meaning tax revenues grew more than twice as fast as the economy. Tax elasticity measures how tax revenue responds to changes in the economic base after adjusting for discretionary changes in tax rates and laws. An elasticity greater than one implies that revenues grow faster than the economy, indicating effective administration and buoyant tax bases.

Direct vs Indirect Taxes: Key Differences

The table below summarises major distinctions between direct and indirect taxes. It uses short phrases rather than long sentences to aid quick revision.

Incidence, Progressivity and Current Trends

In classical public finance, the incidence of a tax is determined by supply and demand elasticities. For direct taxes like income tax, the person legally obliged to pay cannot transfer the burden. The incidence therefore falls on the taxpayer, making the system inherently progressive because tax rates rise with income slabs. Progressive taxation aligns with vertical equity - the idea that those with greater ability should pay a higher proportion. Horizontal equity requires that individuals with similar ability pay the same tax, which is why exemptions and deductions should be limited.

Indirect taxes like GST have the opposite distributional effect. The seller passes the tax through higher prices, so consumers bear the final incidence. Because everyone pays the same rate, lower-income households spend a bigger share of their income on taxed goods, making the tax regressive. Policymakers often address this by exempting or applying lower rates on essential items or by providing targeted subsidies to the poor.

Recent data highlight the shifting composition of India's tax revenue. In FY 2023-24 the contribution of direct taxes to total tax revenue climbed to 56.72 %, the highest in 14 years, while indirect taxes fell to 43.28 %. The direct tax-to-GDP ratio reached 6.64 %, a two-decade high. Personal income tax collections (Rs10.45 lakh crore) exceeded corporate tax collections (Rs9.11 lakh crore) for the second consecutive year. Tax buoyancy increased to 2.12 in FY 2023-24, meaning tax revenue grew more than twice as fast as nominal GDP. The cost of tax collection, a measure of efficiency, declined to 0.44 % of collections-the lowest since 2000-01.

These trends suggest that India's fiscal system is becoming more reliant on direct taxes, which enhance equity, while indirect taxes remain important for revenue stability. Policymakers continue to streamline GST rates and widen the tax base through digital compliance, while schemes like the Vivad se Vishwas and faceless assessment aim to improve voluntary compliance and reduce litigation.

Equity vs Efficiency Trade-offs

Tax policy must balance equity (fair distribution) and efficiency (minimal distortion to economic activity). Progressive direct taxes promote equity by redistributing income but may reduce incentives to save and invest. Excessively high marginal rates can encourage tax evasion and discourage entrepreneurship. Regressive indirect taxes are easier to administer and have broader bases, making them efficient revenue tools. However, they burden the poor more heavily and can dampen consumption when rates are high.

Fiscal theorists propose designing a tax mix that combines progressive direct taxes with moderate indirect taxes. Low rates on essential goods coupled with higher rates on luxury items can improve progressivity. In addition, expanding the tax base through better compliance and reducing exemptions can raise revenues without raising rates. Governments also use compensatory measures, such as targeted cash transfers or subsidised food, to offset the regressive impact of consumption taxes.

Tax buoyancy and elasticity inform this balance. A buoyancy greater than one indicates strong revenue growth relative to GDP; India's buoyancy of 2.12 in FY 2023-24 suggests robust compliance and economic growth. Elasticity measures the responsiveness of tax revenue to GDP after policy changes. Higher elasticity implies that revenues will grow even without raising rates, enabling the government to keep rates moderate and support economic efficiency.

For UPSC Prelims vs Mains

Prelims Pointers

• Know the basic definitions of direct and indirect taxes, and remember that direct taxes cannot be shifted while indirect taxes are passed to consumers.
• Understand progressive, proportional and regressive taxes, with examples (income tax is progressive; corporate tax is proportional; GST is regressive).
• Remember the concepts of tax impact and incidence; for indirect taxes the incidence lies on consumers.
• Note that the share of direct taxes in India's total tax revenue rose to 56.72 % in FY 2023-24 while indirect taxes fell to 43.28 %.
• Recall that tax buoyancy was 2.12 in FY 2023-24 and the direct tax-to-GDP ratio reached 6.64 %.

Mains Notes

• Discuss the rationale for combining direct and indirect taxes in a mixed tax system. Analyse how the progressivity of direct taxes and the efficiency of indirect taxes complement each other.
• Evaluate the equity implications of GST, especially for essentials versus luxury goods. Suggest measures to mitigate its regressive impact while preserving revenue.
• Examine the trends in India's tax composition, including the surge in personal income tax collections and the growing reliance on digital compliance. Comment on the significance of a tax buoyancy above 2.
• Analyse the trade-off between vertical and horizontal equity in personal income tax slabs. Should India introduce a wealth tax or higher surcharges to enhance progressivity?
• Discuss how tax elasticity can guide policymakers in achieving fiscal consolidation without raising rates. Provide examples of reforms (faceless assessments, Vivad se Vishwas) that improve compliance and elasticity.

Quick Facts

• Direct taxes include income tax, corporate tax, capital gains tax and wealth tax. They are progressive and cannot be shifted to others.
• Indirect taxes such as GST, customs duty and excise duty are levied on goods and services; the consumer bears the final burden, making them regressive.
• The share of direct taxes in India's total tax revenue reached 56.72 % in FY 2023-24, the highest in 14 years.
• Indirect taxes accounted for 43.28 % of total tax revenue in FY 2023-24, down from 45.37 % in FY 2022-23.
• The direct tax-to-GDP ratio touched 6.64 %, the highest in more than two decades.
• Tax buoyancy was 2.12 in FY 2023-24, implying tax revenue grew more than twice as fast as nominal GDP.
• Personal income tax collections (Rs10.45 lakh crore) exceeded corporate tax collections (Rs9.11 lakh crore) in FY 2023-24.
• The cost of tax collection declined to 0.44 % of total collections in FY 2023-24.
• Top states in direct tax collections: Maharashtra contributed 39 %, Karnataka 12 % and Delhi 10.4 %.
• Vertical equity means those with more income should pay a higher proportion of taxes; horizontal equity means people in similar circumstances should pay the same.

UPSC Previous Year Questions (Selected)

The following paraphrased questions illustrate how the Union Public Service Commission (UPSC) has examined taxation topics. These questions are for practice; always refer to the official question papers for precise wording.

1. 2017 Prelims: Consider the following statements: 1) Direct taxes are considered progressive because they depend on the taxpayer's ability to pay. 2) Indirect taxes are regressive because they impose a uniform burden on all consumers. Which of the statements is/are correct? Answer: Both statements are correct. Direct taxes like income tax are progressive, whereas indirect taxes like GST have regressive effects.
2. 2019 Mains (GS III): "Explain the difference between the impact and incidence of a tax. How do these concepts help in assessing the equity of the Indian tax system?" Answer: The impact is the initial liability to pay tax while the incidence is the final economic burden after any shifting. In direct taxes the two coincide, whereas in indirect taxes the burden shifts to consumers. Understanding this helps evaluate who actually pays and whether the tax is progressive.
3. 2021 Prelims: With reference to tax buoyancy, consider the following statements: 1) It measures the responsiveness of tax revenue to changes in the tax base after accounting for policy changes. 2) A buoyancy greater than 1 indicates that tax revenue grows faster than the economy. Select the correct answer. Answer: Statement 2 is correct, but statement 1 defines tax elasticity; buoyancy includes the effects of discretionary changes.
4. 2023 Mains (GS III): "India's tax system appears to be shifting towards greater reliance on direct taxes. Analyse the trends and discuss the policy implications." Answer: Candidates should mention the rise in the direct tax share to 56.72 % and the fall in indirect taxes, the increase in the direct tax-to-GDP ratio to 6.64 %, the surge in personal income tax collections, and discuss the progressive nature of direct taxes and the need to broaden the base.

Practice MCQs

1. Which of the following best describes a regressive tax?
   1. A tax that takes a larger proportion of income from high earners than from low earners.
   2. A tax with a constant rate regardless of income.
   3. A tax that takes a larger proportion of income from low earners than from high earners.
   4. A tax applied only to wealth and property.
2. In the context of tax incidence, the term "impact" refers to:
   1. The final burden of the tax on consumers.
   2. The initial liability to pay the tax.
   3. The administrative cost of tax collection.
   4. The indirect effect of taxes on savings.
3. Which of the following statements about India's tax revenue in FY 2023-24 is/are correct?
   1. Direct taxes accounted for more than half of total tax revenue.
   2. Indirect taxes exceeded direct taxes in total share.
   3. Personal income tax collections were lower than corporate tax collections.
   4. Tax buoyancy was less than 1.
4. Tax buoyancy differs from tax elasticity in that:
   1. Buoyancy measures responsiveness without including policy changes; elasticity includes policy changes.
   2. Buoyancy includes discretionary changes in tax rates and bases, while elasticity excludes them.
   3. Both concepts are identical.
   4. Elasticity measures the cost of collection.

Answer key:

1. Answer: C. A regressive tax takes a larger proportion of income from low earners; GST is an example.
2. Answer: B. The impact of a tax is the initial liability or statutory obligation to pay.
3. Answer: A. Direct taxes made up 56.72 % of total tax revenue in FY 2023-24; personal income tax exceeded corporate tax, and tax buoyancy was 2.12.
4. Answer: B. Tax buoyancy includes the effect of discretionary changes in tax policy, whereas elasticity adjusts for those changes.

Frequently Asked Questions (FAQs)

What is the main difference between direct and indirect taxes?

Direct taxes are paid directly by individuals or companies to the government; the burden cannot be shifted to others. Indirect taxes are charged on goods and services, and businesses pass the tax on to consumers through higher prices.

Why are direct taxes considered progressive?

Direct taxes like personal income tax have slab-wise rates that rise with income. This ensures that people with higher incomes contribute a larger share of their earnings, promoting vertical equity and reducing inequality. Indirect taxes, by contrast, impose the same rate on all consumers, making them regressive.

How has India's tax composition changed recently?

According to CBDT data, direct taxes contributed 56.72 % of India's total tax revenue in FY 2023-24, the highest share in 14 years, while indirect taxes fell to 43.28 %. The direct tax-to-GDP ratio rose to 6.64 % and tax buoyancy reached 2.12, reflecting robust revenue growth.