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Direct tax vs. indirect tax

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Last editedFeb 20222 min read

Getting to grips with tax can be confusing at the best of times – but it’s made even more confusing with terms such as “direct” and “indirect tax”. These two types of tax are related, but it’s important to understand the differences between them and how they related to your business. So, what’s the difference between direct and indirect tax? Let’s find out.

What is direct tax?

Direct tax is paid – as the name might suggest – directly to the government. While all taxes end up in the mutual pot eventually, a direct tax payment doesn’t take any detours along the way. These types of taxes are often easier to work out and understand, although the amounts that need paying can vary greatly depending on the amount you earn and whether you’re eligible for any schemes or exemptions. Direct taxes are paid by both businesses and individuals in different ways and usually operate on a percentage basis.

What is indirect tax?

Indirect taxes, on the other hand, take a roundabout route to reaching where they need to go. Indirect taxes are collected at some point along the supply chain but are typically transferred through a middleman before reaching the government.

This type of tax is often referred to in relation to product taxes because they’re typically paid by the consumer via an increased retail price, but the money goes to the retailer before the tax is passed along to the government. These types of tax can sometimes be harder to spot and more difficult to calculate although there are established rules for businesses to follow in relation to products and suppliers.

What’s the difference between direct and indirect tax?

Put simply, a direct tax passes from the payor straight to the government while an indirect tax passes from payor to supplier to government.

When it comes to direct tax vs. indirect tax, the most important difference is the middleman that intervenes before the money reaches its final destination. Both types of taxes can be paid by both businesses and individuals and both types are mandatory, although indirect taxes can sometimes be covered in different forms. For example, the supplier may not pass the whole cost along to a customer and may instead cover some of the tax amount themselves in order to keep prices competitive.

Direct and indirect tax examples

Both direct tax and indirect tax come in many different forms.

One of the most common examples of direct tax is income tax. This type of tax is paid by all workers in the UK who earn an amount above the minimum threshold. This is true of money earned abroad as well as income earned in the UK - assuming they remain a resident of the UK. It can be confusing to think of this type of tax as a direct tax because many employees pay their tax via PAYE and so it is deducted from their pay cheque without the employee ever handling the money. However, the important factor is that the tax is taken by the government rather than handled by the employer.

A typical example of indirect tax is value-added tax or VAT. This is a percentage added to all non-essential goods in the UK. This is an important figure for businesses to know because businesses which pass a certain threshold are required to register for business VAT in the UK. Businesses that fall below the threshold can also opt to register for VAT but it’s not mandatory and is worth discussing with a financial advisor to decide if it’s beneficial first.

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