A direct tax is a tax levied on a person or on property, and its burden is meant to rest on the same party that pays it, so it cannot be shifted forward to another party in a transaction. An indirect tax is laid on an activity or a transaction instead, and whoever remits it can pass it along in the price. The distinction is one of incidence, meaning who ends up out of pocket rather than who writes the check.
What the Constitution Requires of a Direct Tax
The label decides which of two constitutional rules a federal tax has to satisfy. Article I gives Congress the power to lay and collect taxes, duties, imposts and excises, and requires that all duties, imposts and excises be uniform throughout the United States (U.S. Constitution, Article I, Section 8). Direct taxes answer to a different rule. Representatives and direct taxes are apportioned among the several states according to their respective numbers (Article I, Section 2, Clause 3), and no capitation, meaning a tax laid at a fixed amount per head, or other direct tax may be laid unless in proportion to the census (Article I, Section 9, Clause 4).
Apportionment in that sense means dividing the tax among the states by population, so a state holding five percent of the people carries five percent of the total however much of the taxed thing sits there. The Supreme Court called that result politically unpalatable and hard to enact, and noted that the parties before it cited no apportioned direct taxes in the current Internal Revenue Code and that Congress appears not to have enacted an apportioned tax since the Civil War (Moore v. United States, slip opinion at 6).
Income tax is where the constitutional sorting stops matching ordinary usage. The Sixteenth Amendment gives Congress power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration (U.S. Constitution, Amendment XVI). Reading that amendment with Article I, the Court treats taxes on income as indirect taxes that need not be apportioned, while property taxes remain direct taxes that must be (Moore v. United States, slip opinion at 7). The requirement limits what Congress may lay, so a state or local property tax is untouched by it.
Which Charges a Firm Meets on Each Side
Read on incidence, the direct side of a US firm’s own tax picture is short. Federal and state income tax on the firm’s profit sits there, and which return carries that figure is traced in federal income tax liability. So does self-employment tax, which the Code imposes for each taxable year on the self-employment income of every individual (26 U.S.C. 1401(a)). Property tax on real estate the firm or its owner holds belongs there too, assessed against the property and billed to whoever owns it.
The indirect side is the side a firm handles for somebody else. A client selling taxable goods or services collects sales tax from its customers and remits it as a trustee for the state, and certain responsible persons of the business can be held personally liable for that money (New York State Publication 750, A Guide to Sales Tax in New York State). Excise taxes belong on the same side, inside the duties, imposts and excises category the uniformity rule covers. A foreign value added tax turns up on the buy side, on invoices from vendors abroad, and its credit and invoice machinery is worked through in value added tax.
What Direct Tax Gets Confused With
Incidence Is Not the Rate Structure
Direct and indirect answer who bears the charge. Proportional, progressive and regressive answer what the rate does as the base grows, which is a separate axis and is set out in proportional tax. A direct tax can carry a single rate or a graduated one, and so can an indirect tax, so neither label tells you anything about the other.
Who Remits Is Not Who Bears
The party that files and pays is not always the party the charge lands on. A seller collecting sales tax hands over money that came from the customer, which makes it a collector rather than a payer. Sorting on shiftability alone moves things around. The IRS teaching lesson on this pair says income and property taxes are paid directly to the government, then defines an indirect tax as one that can be shifted to others and offers business property taxes as its example, since a business can recover them through prices, wages or profits (IRS, Understanding Taxes, Theme 4 Lesson 4). Name the test before you use the label, because legal incidence and economic shifting do not always land in the same place.
Constitutional Apportionment Is Not State Apportionment
Apportionment does two different jobs in a tax practice. In Article I it means dividing a federal direct tax among the states by population. In state income tax it means the formula split of a multistate business’s apportionable income among the states that may tax it, which is the sense worked through in apportionment. One word, two mechanisms, and only the first is a constitutional limit on Congress.
Common Questions
A property tax holds up in both senses, since it is assessed on the property itself and the Court treats property taxes as direct taxes that must be apportioned (Moore v. United States, slip opinion at 7). Income tax is the example most sources reach for, and it is direct in the everyday sense that the person taxed pays it and cannot hand it to a buyer, though the constitutional sorting files it with the indirect taxes.
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