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Direct tax

It includes income tax, wealth tax and gift ta.
Income taxes
  • Income tax in India was introduced in 1860, but was discontinued in 1873 and reintroduced in 1886
  • It is levied on the income of individuals, or entities like firm, Companies, HUF, etc.
  • For taxation purposes, incomes from all sources are added and certain rebates, deductions, expenditures etc. on account of life insurance, savings in provident fund etc. are allowed
  • The system of tax in India is progressive i.e. higher the income, higher is the tax
Income tax is of two types.
  • Personal income tax: It is levied on the income of individuals, Hindu Undivided Families, unregistered firms and other association of persons.
  • Corporate tax: It is levied on the incomes of registered companies and corporations. The underlying principle for corporate tax is that a joint stock company has a separate entity and thus, should be taxed separately. Tax rates are different for domestic and foreign companies. Certain types of companies are given tax exemptions and also receive the benefit of tax holidays.
  • Taxes on wealth and capital
  • Prominent among these are estate duty, annual tax on wealth and gift tax
  • Estate duty was introduced in India in 1953. Upon the death of a person, the total property is passed on to the heirs and tax is levied on that. This was a minor source of revenue and was abolished in 1985
  • Wealth tax introduced in India in 1957 and was levied on wealth such as land, bonds, shares etc. of people. In 1993, wealth tax was abolished on all assets except certain specified assets like residential houses, farm houses, jewellery, bullion, etc. as this was a meagre source of income.
  • Gift tax was first introduced in 1958 and was to be levied on all donations to recognized charitable institutions, gifts to women dependents and gifts to wife. Gift tax was removed in 1998 but partially reintroduced in April 2005. If gifts received is more than ₹ 50,000 it is made Taxable under the head “Income from other sources”.

Indirect taxes

  • Custom duties: They are levied on exports and imports. Import duties are generally levied on the basis of ad valorem, that is, they are determined as a percentage of the price of the commodity. The prices of certain commodities like crude oil, steel and food etc. shot up worldwide during the first half of 2008-09 which had an adverse affect on their domestic prices and demand. Hence, custom duties on many commodities were reduced as an anti-inflationary measure.
  • Excise duties: They are levied on production. Excise duties are levied in total ignorance of the actual sales. They are levied by the Central Government and in a number of forms.
There are a number of limitations imposed on taxation on inputs such as raw materials, components and other intermediaries. It often distorts the production structure, and leads to a cascading effect on taxes, which implies that tax liability gets compounded. As a result of this, a correct assessment of tax incidence becomes difficult.



Raghu buys cloth material for 10,000 and pays a tax of 1,200 on the same. He processes this material into 10 beautiful sarees which he sells each for  2,000 plus tax of  200 on each to a wholeseller merchant, Madan. Madan sells these sarees for  2,300 plus tax of  230 on each. Here, the same material is taxed multiple times there by leading to cascading effect on taxes. Hence, the government introduced Modified Value Added Tax (MODVAT) in 1986- 87, to stamp out these defects.


Value Added Tax is the difference between a firm’s revenue and its payments to outsiders [Sales- Purchased items]. A manufacturer got full reimbursement of excise duty paid on the raw materials or components under MODVAT. This system prevented payments of duties on earlier duties paid. However, it suffers from a major drawback which is the existence of a many rates on outputs and inputs leading to dispute relating to the classification of both, the outputs and inputs.
To overcome these problems, Central Value Added Tax (CENVAT) was introduced. CENVAT consists of only one basic excise duty of 8% and some special excise duties. Special excise duties are in addition to CENVAT. It is to be levied on specific goods. The basic excise paid can be deducted from the excise collected on the output so that only tax on value added is paid. CENVAT, being simple, will result in the transparency in the system of union excise duty. The cascading effect of input taxation was reduced by CENVAT. Account based systems wipe out the need for physical checking of goods.
Sales tax:
It is levied on business transactions. It differs from excise duty in certain respects. Sales tax is more in the case of luxury items and less or almost nil in the case of necessities.
Registered trading concerns that are required to pay sales tax shift the burden to the customers. Sales tax is in two forms – state sales tax and central sales tax. State sale tax is on transactions within a state, while central sales tax is inter-state tax. Sales tax is being replaced by Value Added Tax in all states. Central sales tax is distinct from the system of VAT. It is being planned out in stages. At present, it is 2%.
Sales tax suffers from the following defects:
  • Cascading effect
  • Lack of transparency
  • Narrow base
  • Different procedures followed by different states


Value Added Tax (VAT) is a multistage sales tax with credit for taxes paid on busines purchases. It is levied on value addition at each stage of transaction in the production distribution chain. A set off will be given for input tax as well as for tax paid on previous purchases.



If inputs are purchased for  50,000 and sales are worth  2,00,000 in a month and input tax rate and output tax rate are 10%, the input tax credit and calculation of VAT is: (2,00,000 x 10%) – (50,000 x 10%) =  15,000.

VAT was introduced in 1999 and was implemented in April 2005 in some states. At present, all the states and union territories have implemented VAT.
Benefits of VAT
  • Set off is allowed on input tax and tax paid on previous purchases
  • Turnover tax, surcharge and other taxes will be abolished
  • Overall tax burden will be rationalized
  • Prices, in general, will fall
  • There will be an increase in revenue
  • Self-assessment is possible
  • It leads to increased transparency
  • It is non-cascading
Number of units (juice)
(a) Purchase of raw materials by a dealer/manufacturer
(b) VAT on inputs at 4% on 1,00,000 [This is called input VAT or VAT credit available]
(c) Total cost of raw materials/inputs
(d) Sale value of output/finished goods
(e) VAT on output i.e. output tax payable on sales at 4% on 4,00,000
(f) Less: VAT credit on inputs/raw materials, now set-off [Item (b) above]
(g) VAT payable after set-off of input VAT credit


Note: In India, presently VAT/input tax set-off is applicable for excise duty, customs duty, service tax and sales tax.

Service tax

It is a form of indirect tax imposed on specified services called taxable services. It was introduced in 1994-95. Today, service tax network covers more than 120 services.
The rate of service tax was revised from 5% in 2002-03 to 12% in 2008-09. From 24.02.2009, it has been reduced to 10%.

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