Taxes are broadly divided into two categories: direct and indirect. Direct taxes are those paid by taxpayers directly to the government, such as income tax, property tax, and other taxes levied on assets owned by an individual or entity.
To help illustrate what a direct tax is, we’ll explain how direct taxes work, the types of direct taxes you may be required to pay, and the main differences between direct and indirect tax.
Definition and Example of Direct Taxes
A tax you pay directly to the government is known as a direct tax. For example, federal income tax is a common direct tax. The amount of income tax you pay depends on how much you earn, whether you’re single or married, whether you have children or other dependents, and other factors.
Direct taxes must be paid by the person or entity that incurred them, unlike indirect taxes, which can be passed on to others.
For example, the excise tax on gasoline is a common type of indirect tax. The federal government charges an excise tax of 18.4 cents per gallon on gas, which is paid by the manufacturer but generally passed on to the retailer then the consumer.
How a Direct Tax Works
Direct taxes are pretty simple: The federal, state, or local government imposes a tax on a person or entity, who then pays the tax directly to the government.
For example, in general, the federal income tax brackets levy larger percentages of income tax on higher incomes, and smaller percentages on lower incomes. This progressive tax system means that people who earn more money pay more income tax directly to the government.
As taxpayers' incomes increase, so does the percentage they pay in taxes, but only on the amount of the increase.
Taxes are a much-debated component of the economy, but generally speaking, they exist to fund various government programs and services such as Social Security, Medicaid, and other citizen well-being initiatives. They also help fund civic repairs, public transportation, and other beneficial services.
Types of Direct Taxes
Direct tax is a broad term that includes several types of taxes paid directly to the government, including:
- Income tax: You’ll pay a percentage of your earnings to the government as income tax. Everyone is subject to federal income taxes, and most states charge income tax as well. For example, in 2021 California charges up to 13.3%, while Texas and Washington don’t charge any income tax. Depending on where you live, you may also pay municipal income taxes.
- Capital gains tax: This is a form of income tax measured by how much value your assets have gained from the point of acquisition (when you bought them) to the point of sale. You’ll pay capital gains tax along with other taxes when you file your tax return.
- Property tax: Property tax is paid on each piece of property a taxpayer owns, including land, houses, and any other buildings. Property taxes are calculated based on the geographical location of the property, the market value of the land, and an estimate of the home’s value.
- Personal property tax: Some states, including Connecticut, Mississippi, and Virginia, also charge personal property taxes on movable items such as cars, boats, and RVs. If you live in one of these states, you may pay an additional direct tax based on the value of these items.
- Direct tax is a broad category that includes property tax, income tax, capital gains tax, and other taxes paid directly to the government.
- Direct taxes can’t be transferred to another individual or entity. They must be paid by the person or organization who incurred them.
- Federal, state, and municipal tax guidelines vary and can significantly affect the amount of tax you have to pay.
Frequently Asked Questions (FAQs)
If I accept a job that pays $5 million per year, will I have to give up over a third to taxes?
No, not exactly. Even though your income puts you in the highest tax bracket, you won't pay the marginal tax rate on all of your earnings. In fact, you will be taxed the same way as everyone else in the given bracket: In 2022 you'll pay only 10% on the first $10,275, then 12% on the next portion, and so on, working your way up the marginal brackets. You'll only pay the maximum 37% on the portion of your income that exceeds $539,990.
What do my income taxes pay for?
When you pay income or other direct taxes, the money goes straight to the state or federal government to fund various programs and initiatives. Social services, infrastructure, national defense, and government debt are some of the things that citizen taxpayers help pay for each year.