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I understand that the classification of taxes is on ability-to-pay principle and is partly determined by the demand elasticity of the commodity or service.

That's how I understand income tax is direct, while customs tax is indirect.

But I can't really wrap my head around why corporation tax is also considered a direct tax. Can't the corporations simply raise their prices in order to shift away the incidence of tax burden?

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    $\begingroup$ I'm not sure I get your classification. My understanding is that a direct tax is a tax imposed on the same individuals/organisations by which the tax is collected, whereas an indirect tax is such that the entity taxed is not the same as the one who collect the taxes. As such, corporation tax is clearly a direct tax, whereas VAT is an indirect tax, collected by retailers/seller, but paid by consumers. Surely, corporations can raise their prices, but that does not mean that profits, which is what the corp tax is aiming for are to remain the same. They might well fall. $\endgroup$ – luchonacho Apr 12 '17 at 8:44
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The classification of direct vs indirect taxes is outdated and has nothing to do with the effects of taxes on behaviour. This classification is mostly due to historic reasons.

Direct taxes are taxes on property, businesses or people. They tax entities directly and not through their behavior. This doesn't mean, however, that these taxes don't have behavioral effects.

Indirect taxes are taxes on transactions and exchanges, since they are not taxing entities themselves, but their behaviour.

The classification is not very meaningful nowadays. For example the estate tax is direct (it directly taxes the estate), whereas the inheritance tax is indirect (it taxes the transaction from parent to child). However, these two taxes are economically equivalent.

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According to the 1987's edition of the Palgrave Dictionary of Economics (subscription required):

It is conventional to describe direct taxes as taxes where the person legally liable to pay the tax is also the person whose income or welfare is reduced as a result of its imposition: while indirect taxes are those where liability can be shifted to someone else. This distinction is essentially an arbitrary one. All taxes can be shifted to some degree: only in exceptional circumstances can any agent shift a tax completely. In common usage, indirect taxes are those which are paid by retailers, wholesalers or manufacturers, but believed to be shifted toward final consumers.

The first take away is that these are conventions. Second, based on the above convention, a corporation tax directly affects the income of the company (and their owners), as that income could have otherwise been reinvested (to increase future profits) and/or taken away by owners. Maybe some firm have some leeway to shift their tax duties to consumers (specially if you believe that there is a natural/efficient/optimal after-tax rate of return on equity to which firms converge), but I'm not sure there is convincing evidence that changes in tax rates are transmitted 1-to-1 to prices.

In any case, as the quote above says, all taxes can be shifted to some degree, so the definition of in/direct tax remains primarily customary.

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"Direct tax" is just another term for "Income Tax". This has historical roots: the concept of tax is that, from each producer the state has the right to take part of its production. This is how tax has been historically conceived in human societies.

Who actually collects the tax and pays it to the government does not enter the classification: for example, in many countries, the income tax of employees are retained (essentially collected) by the employer and paid to the tax authority by him -but this is still correctly classified as a direct tax.

How the entity under taxation reacts to the tax also doesn't matter for the classification, which is seen to be essentially void of behavioral content, even though it is certainly linked to behavior, since more or less indirect taxes emerged because governments realized that these are more easily collected.

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  • $\begingroup$ But isn't it that the taxes are classified on the basis of impact (initial point of imposition) and incidence (point of settlement), in that taxes whose incidence can be shifted (onto the consumers for instance) are indirect taxes and the rest, direct? Are you arguing that this classification is instead a matter of convention and doesn't have anything to do with the ability of the producer to shift incidence - probably dude to inelastic demand? If not, can you explain why just like sales tax or customs tax, corporations cannot shift the burden of corporation tax too- like by deduction from pay $\endgroup$ – Harman Deep Apr 13 '17 at 4:41

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