Direct vs Indirect Taxes & The Impact on YOU

May 11, 2018

As we’ve seen up close here on our blog, there are many, many different kinds of taxes. There are poll taxes, excise taxes, sales taxes, use taxes, income taxes, self-employment taxes, value added taxes – the list just keeps going and going. To raise revenue, states develop all sorts of different taxes to extract funds from populations.  These taxes fall into different categories. In taxation, all taxes fall into one or more broad categories of tax; for instance, an “excise tax” is a very large category which encompasses every tax imposed on a particular good, and so sales tax is a specific variant of excise tax One way to differentiate between the various taxes is to characterize them as direct vs indirect taxes.

As it turns out, these two categories of tax, which can accurately be described as the two largest or broadest categories of tax are, for all practical purposes, defunct. In this article, we will discuss in detail the concept of direct  vs indirect taxes, and highlight the significance of these two classifications. Even though these classifications don’t carry the same type of practical value as previously, understanding them is still highly useful.  That’s because our system of taxation centers around these categories to a large degree. 

Constitutional Foundation of Direct vs Indirect Taxes

The dichotomy between direct taxes and indirect taxes traces its origins to well before the emergence of the United States as a sovereign nation. Adam Smith, the famous economist, discussed this dichotomy in his magnum opus, The Wealth of Nations. However, the distinction between direct taxes and indirect taxes acquired a new meaning in the United States with the development of the Constitution. The authors of the U.S. Constitution saw the distinction between these taxes as having significance for the protection of individual liberty and justice, and so the distinction was codified in the Constitution as a means to guard against governmental oppression.  

The Constitution requires apportionment of direct taxes.  The relative population of a state controls apportionment.  Classifying a tax as indirect means that it is uniformly imposed. An example of a direct tax is a poll tax.  Other terms for it are “head tax,” or capitation.  They are a type of tax aimed specifically at an individual, as opposed to a good or transaction. An example of an indirect tax is a tax on wages.  That’s because such a tax is collected for the service provided by the laborer, rather than on the laborer. In the U.S. Constitutional system., direct taxes and indirect taxes are the two “super categories” under which all other tax categories and specific kinds of tax fall. 

Not A Straightforward Issue

One issue with this system was the fact that distinguishing between these two categories was not always a straightforward matter.  There were generally accepted principles underlying these classifications.  Nonetheless, there were no systems to help classify a given tax in every conceivable instance. But the basic purpose behind the integration of this dichotomy in the original Constitution was avoidance of oppressive taxation and, therefore, tyranny. 

Overturning the Inherent Dichotomy Between Direct vs Indirect Taxes

The issue of classifying taxes came to the fore at the close of the 19th century when the income tax provision of the Wilson-Gorman Tariff Act of 1894 was declared unconstitutional in the landmark decision of Pollock v. Farmers’ Loan & Trust Co. (1895). This decision was highly controversial.  That’s because, traditionally, taxes on wages, or labor, were indirect taxes.  As a result, the income tax provision was thought an indirect tax. However, the Supreme Court decision rests on the fact that the income tax provision includes income derived from property, such as rents, dividends and interest payments. Because of their inclusion in the income tax, the Court saw it as a direct tax.  In consequence, the income tax portion of the tariff act was held unconstitutional.  

Post Pollock

After the Pollock decision, the political establishment  came to a new understanding.  Specifically, that, for a federal income tax to be constitutional, the distinction between direct and indirect taxation must go. The reason for this was that apportioning income tax without an amendment leads to enormous practical difficulties. This eventually led Congress to pass the Sixteenth Amendment, which essentially threw out the dichotomy of direct vs indirect taxes, thereby allowing the federal government to collect taxes without regard to their classification or source.  In other words, after the amendment, the apportionment requirement no longer constrained government. The distinction between direct and indirect taxes became virtually meaningless. After the amendment, direct taxes and indirect taxes became useful only as theoretical concepts.  Gone was their practical impact from the early days of the Constitution. 

Understanding the distinction between direct vs indirect taxes is important for a variety of reasons. This distinction help us understand the evolution of our system of taxation.  It’s also useful to grasp how and why tax categories form.  Whether a tax falls into one category or the other can make a world of difference.  This distinction clearly shows that. This distinction has no current meaning.  Nonetheless, it’s always possible that these categories can come alive again.  Or, other governments may adopt and utilize them.

Our New York City Tax Attorneys Can Help

The attorneys at Mackay, Caswell & Callahan, P.C. do their best to understand the world of taxation in all of its complexity.  That includes keeping track of how our system of taxation grew over time. If you have a debt resolution, IRS collection or other type of tax issue, contact us.  One of our New York tax attorneys is sure to respond and give you top quality assistance today. 

Image credit: Marco Verch 


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