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Taxation: A Friendly Guide to What They Are and How They Work

Define The Term Tax, Meaning And Essential Of Taxes Explain The Nature And Characteristic Of Tax: Different Types Of Taxes And Distinguish It From Fees And Cess.

Taxation is the most important component of the financial structure of any country. Taxes are imposed upon individuals and business entities that are paid to the government or the state. Taxes are considered to be contributions made by individuals and business entities for economic growth and development.

To run a nation judiciously, the government needs to collect tax from the eligible citizens; paying taxes to the local government is an integral part of everyone's life, no matter where we live in the world.

Now, taxes can be collected in any form such as state taxes, central government taxes, direct taxes, indirect taxes, and much more. For your ease, let's divide the types of taxation in India into two categories, viz. direct taxes and indirect taxes. This segregation is based on how the tax is being paid to the government.

In simple terms, it is the source of revenue for the government to manage public expenditure. On the contrasting side, taxes are involuntary payments made by the individuals and business entities to the government which decreases their annual income or profits. Going by the normative standards, it has been understood that taxes should be levied in such a manner that they don't pinch the taxpayer.

In other words, the conflict of interest in taxation is managed by adhering to principles like fairness, transparency, effectiveness, and efficiency. Taxation is a complex and interdisciplinary subject, involving law, economics, and accountancy. With the increasing globalisation of economies, tax laws now consider international relationships between nations. This makes taxation not just about the interests of taxpayers and governments but also involves navigating the interactions between different countries subjected to these tax rules.

A tax is a mandatory fee charged by a government on an individual or an organisation to collect revenue for the benefit of the population. This collected revenue is used to finance projects for the public welfare and public interest.

Projects that benefit the general population, the public interest, and social welfare, such as schools, bridges, infrastructure, and hospitals, can be financed by taxes. Many initiatives by the government that don't have significant economic benefits are also supported by taxes paid by the citizens. All persons and legal entities in India are subject to taxation.

Legal tax entities such as corporations, development organisations, associations of people, and non-profit organisations are liable to pay both indirect and direct taxes. A taxpayer may also be required to pay customs fees when bringing products into India. So, now that you have a brief understanding of the tax meaning, let's learn more about its types.

The tax structure in India is a three-tier structure: local municipal bodies, state, and central government. Typically taxation in India is broadly classified into direct tax and indirect tax. Let us look at these two types of taxes and catch the difference between direct and indirect taxes.

Direct Taxes

Direct tax is levied on the income or profits of people. For example, a taxpayer pays the government for different purposes, including income tax, personal property tax, FBT, etc. The burden has to be borne by the person on whom the tax is levied and cannot be passed on to someone else. Direct tax is governed and administered by the Central Board of Direct Taxes (CBDT).

Types Of Direct Tax

  • Income Tax: A tax levied on the income earned by individuals and businesses. It is based on the total income or profits earned, and rates may vary based on income levels.
  • Corporate Tax: A tax on the profits earned by corporations. It is applied to the company's net income after deducting expenses and is usually calculated at a specific rate.
  • Securities Transaction Tax (STT): A tax on the value of securities transactions, such as buying or selling stocks. It is aimed at taxing profits from the securities market.
  • Capital Gains Tax: A tax on the profit earned from the sale of assets, such as stocks or real estate. It can be short-term or long-term, depending on the holding period.
  • Gift Tax: A tax on the transfer of assets or money as a gift. It is applicable when the value of the gift exceeds a certain threshold.
  • Wealth Tax: It is a type of direct tax levied on the net wealth or assets owned by individuals, businesses, or other entities. It is distinct from income tax, which is based on earnings. Wealth tax is assessed on the total value of one's assets, which may include real estate, cash, bank deposits, investments, jewellery, and other valuable possessions.

Indirect taxes
Conversely, indirect tax is levied by the government on goods and services. Therefore, it can be shifted from one tax-paying individual to another. E.g. The wholesaler can pass it on to retailers, who then pass it on to customers. Therefore, customers bear the brunt of indirect taxes. Indirect taxes are governed and administered by the Central Board of Indirect Taxes and Customs (CBIC).

Types Of Indirect Tax

  1. Sales Tax: A consumption tax imposed on the sale of goods and services. It is usually a percentage of the sale price and is collected at the point of purchase.
  2. Service Tax: A tax on certain services provided by businesses. It is applied to the value of the services rendered and is collected by the service provider.
  3. Octroi Duty: A local tax levied on the entry of goods into a municipal area. It is often imposed on goods brought into a city or town for consumption.
  4. Value Added Tax (VAT): A consumption tax levied at each stage of the production and distribution chain. It is based on the value added to a product or service at each stage.

GST, or Goods and Services Tax, it is a value-added tax levied on the supply of goods and services. It is a comprehensive indirect tax that has replaced multiple indirect taxes in many countries, aiming to streamline and simplify the taxation system. The fundamental principle of GST is to tax the value addition at each stage of the supply chain.

Essential elements of tax:
  1. It's an enforceable contribution
  2. It is generally payable in money
  3. It is proportionate in character
  4. It is levied on person property or the exercise of a right or privilege (excise tax)
  5. It is levied by the state which has jurisdiction over the subject or object of taxation
  6. It is levied by the law making body of the state
  7. It is divided for public purposes or social causes

Characteristics Of Taxes

  1. Tax is compulsory: The law imposes taxes. Taxes are therefore payments that citizens must make to their governments. Every person has a responsibility to pay his fair share of taxes to support the government. Taxes must be paid in full; failing to do so results in punishment or is considered a criminal offence by the courts. When someone purchases goods, utilises services, earns income, or any other condition of compulsion is discovered, the government applies tax. When collecting taxes from its inhabitants, the government exercises its sovereign authority.
  2. Tax is contribution: To contribute is to assist or offer anything. Taxes are community contributions made to the government. Every citizen has a responsibility to pay their fair share of taxes to support the government and assist it in covering its expenses. Some desires, like defence and security, are shared by every member of the society, therefore individuals cannot satisfy these desires. Governments provide these societal needs, hence people support the government to fulfil these needs. Contribution entails sacrifice or loss on the part of the contributor. His income is impacted by these sacrifices.
  3. Tax is for public benefit: Taxes are collected for the benefit of society as a whole, not to benefit any particular person in particular. Government revenue is used to provide services that benefit all citizens equally, including relief from natural disasters like floods and famine, national defence, the upkeep of the law, and the establishment of infrastructure and order. All people are eligible for such rewards.
  4. No direct benefit: All taxes are required to be paid, and the government does not directly reward taxpayers for their contributions. The absence of a direct quid pro quo between the taxpayer and the public authority distinguishes taxes from other levies made by governments. Taxes are distinct from other types of government taxes and levies that may provide direct benefits to payers, such as pricing, fees, fines, etc. All members of society receive common benefits through taxes.
  5. Tax is paid out of the income of the taxpayer: Income is defined as money received for employment or from investments, especially on a regular basis. As long as the revenue is recognized in this case, the tax must be paid out of it. Any business owner who makes money should give the government his fair share as support.
  6. Government has the power to levy tax: Through the collection of taxes, governments exercise sovereign control over their constituents. People's taxes can only be collected by the government. Resources are being moved from the private to the public sectors through taxes. The tax is being levied by the government to pay for its expenses. The government uses these taxes to promote economic growth and social welfare.
  7. Tax is not the cost of the benefit: Taxes do not represent the price of the benefits that the state provides to the populace. Benefit and taxpayers are independent of one another, and the purpose of paying taxes is of course to provide benefits to the broader public.
Tax is for economic growth and public welfare : Maximising social welfare and economic prosperity is a key government goal. The two processes that make up a nation's development are often raising money and spending it, thus the government uses tax money to improve the economy, the community, and society as a whole.

Nature Of Tax

  • Compulsory Payment: Taxes are mandatory payments enforced by the government. Citizens and businesses are legally obligated to pay taxes on their income, property, transactions, or other taxable activities.
  • Revenue Generation: The primary purpose of taxes is to generate revenue for the government. This revenue is used to fund public services, infrastructure, social welfare programs, defence, and other essential functions of the state.
  • Redistribution of Wealth: Taxes can be designed to redistribute wealth within a society. Progressive tax systems impose higher rates on higher income levels, aiming to reduce income inequality.
  • Legal Basis: Taxes are levied based on laws and regulations enacted by the government. The legal framework defines the types of taxes, tax rates, exemptions, and the procedures for tax collection and enforcement.
  • Variety of Taxes: There are various types of taxes, including income tax, sales tax, property tax, corporate tax, and others. Each type serves a specific purpose and is levied on different aspects of economic activities.
  • Fairness and Equity: Principles of fairness and equity are often considered in tax systems. Progressive taxation, where higher-income individuals pay a higher percentage of their income in taxes, is one way to address these concerns.
  • Complexity and Interconnectedness: Taxation is a complex system that is interconnected with various aspects of the economy. It involves interactions between individuals, businesses, and the government, and it is influenced by economic, social, and political factors.

Distinguish Between Tax, Fees, Cess

Fees confer a special capacity although the special advantage as for example, in the case of registration fee for documents or marriage licence is secondary to the primary motive or regulation in the public interest. It is the special benefit accorded to the individual, which is the reason for payment in the case of fees. In the case of a tax, the particular advantage if it exists at all, is an incidental result of State action.

Fee is a sort of consideration for the services rendered, which necessitate that there should be an element of quid pro quo (advantage granted in return). Therefore co-relationship must exist between the fee charged and services rendered.

It is, however, not necessary that those services mathematically are proportionate or equal with the benefit to the person charged or necessarily is uniform. At the same time it may not be excessively disproportionate.

One of the most prominent fees statutorily collected in Pakistan is "TV License Fee", that was included in electricity bills from July 2004, in return state run TV offers free of cost viewing ship.

"The distinction between Fee and Tax was clearly elaborated" by a Division Bench of the Dacca High Court in the case reported as Abdul Majid and another v. Province of East Pakistan and others (PLD 1960 Dacca 502) and it was held unless the fee was embarked or specified for rendering services to the payee, it would amount to a tax and not a fee."

A Cess is a tax confined to a local area for a specified object or a particular purpose. It is in fact species of the same class to which Tax belongs, therefore, no quid pro quo (advantage granted in return) between the services rendered and the imposition is necessary to maintain its validity. It is also a form of tax levied by the government on tax with specific purposes till the time the government gets enough money for that purpose.

Cess is a form of tax levied over the liability of a taxpayer.It is additionally when the Central or the State Government raises funds for a purpose.For e.g. government levies an education cess in order to generate revenue for funding primary to higher education.This is imposed as a percentage of the taxpayer's basis.

Types of Cess in India:

  • Education Cess: This was introduced in order to provide standard quality of education.
  • Health And Education Cess: This was proposed in 2018, by Finance Minister Arun Jaitley. This was brought up in order to meet the education and health needs of rural and Below Poverty Line families.
  • Krishi Kalyan Cess: This cess was aimed at developing the agricultural economy, this was collected at the rate of 0.5%.
  • Infrastructure Cess: This was imposed on the production of vehicles.

Who pays the Cess?

Cess is levied on direct taxes,it is added on the basic tax liability of the taxpayer,which is paid as the total of the tax paid by the taxpayers themselves.In case of Indirect tax,the cess is paid by the producer of goods and services.
Tax Cess
Type of Fee Tax
Definition A mandatory fee charged by a government on a product, income, or activity. Technically, it is just another word for tax. The term might be used in regard to a specific type of tax.
Purpose To generate revenue for the government To generate revenue for the government
Types Direct Tax : tax levied directly on personal or corporate income
Indirect Tax : tax levied on the price of a good or service
Usually used in regard to Local tax and/or Land and Property tax.
Usage The word is used all over the world and in all manners to refer to any type of tax. The term is still frequently used in a few countries including Britain, Ireland, to indicate a local tax, Scotland, to indicate a land tax, and India, applied as a suffix to indicate a category of tax such as 'property-cess'.

In my personal opinion, the best way to comprehend and decode laws related to taxation would be to study it as an interdisciplinary subject. The correlation of the legal aspect of taxation would be much easier to understand when one would be acquainted with the basic principles of accountancy and economics. The present article is articulated especially for the beginners who are planning to indulge in the practice of taxation laws. By establishing the nexus of the provisions of tax laws, one would be in a better position to identify the intentions of the legislature in formulating laws on the subject.

Written By: Rana Saman, 4th Year BA LLB Al-Ameen College Of Law

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