TAXATION

• LESSON’S OBJECTIVES
• What is tax?
 DEFINITION OF TAX
• ‘Tax is a compulsory levy imposed by the
government on the income, goods and
properties of the people living within its
jurisdiction.’
 Reasons for tax

• Raise revenue for government spending.

• To promote redistribution of income and
wealth.
• Discourage consumption/production of
goods with negative externalities or
demerit goods.
• To upset balance of payment
disequilibrium.
 WHAT ARE DIFFERENT TAX
CLASSIFICATION?

• Taxes can be classified based on the

following:
• 1.The tax payer: Who makes the actual
payment of the tax? In this case we
have Direct and Indirect taxes
• 2. The ability to pay: Here, we have,
progressive, proportional and regressive
taxes. These can be merged into
vertical and horizontal axis.
 How each tax is charged
• Income tax – a percentage of income.
• Corporation tax – a percentage of a firm’s profit.
• Sales tax/VAT – an indirect tax on the sale of
goods.
• Excise duties – taxes on alcohol, tobacco, petrol.
• Production taxes – taxes on particular
goods/services, e.g. gambling tax, airlines, insurance.
• Environmental taxes – taxes on carbon, airports
e.t.c.
 How each tax is charged – cont.
• Stamp duty – tax on buying a house or shares.
• Tariff – this is a charge levied on the import of particular goods.
• Inheritance tax – a tax levied on the estate of a deceased person.
• Wealth tax – a tax levied on wealth, rather than income.
• Capital gains tax – a tax levied on an increase in the value of
assets/wealth.
• Poll Tax – a tax on individuals. Introduced in UK as the “Community
Charge”
• Windfall taxes – These are a type of corporation tax levied on
companies making ‘excess’ profit. The UK introduced windfall tax on
privatized industries. Also levied on particular industries like north
sea oil
• Council taxes – taxes collected by local government, could be a tax
on property or local sales/income tax
 Direct and Indirect taxes
(DIRECT TAXES)
• Direct taxes are taxes paid directly to the government tax
authorities by the taxpayer. Direct taxes are collected at source.
For example, under PAYE when an employer pays you, income tax
are automatically taken off
• EXAMPLES
• Income Tax
• Corporation Tax
• Capital Gains Tax
• National Insurance Contributions
• Statutory Payments
• Inheritance Tax
• Petroleum Revenue Tax
• Student Loans
• Stamp Taxes
 Impact of direct taxation – income tax

• Income tax is a levy on income earned. In the UK, the basic rate
of income tax is 20%. If there is an increase in income tax, what
impact does it have?
• Raise revenue for the government. The main purpose of tax is to
raise income for the government which can lead to higher
spending on health care and education. The impact depends on
what government spend the money on. For example, it may be
necessary public sector investment (repairing roads) or it could be
to fund shortages in pension funds)
• Less discretionary income (disposable income). Those paying
income tax will be left with less discretionary income to spend
after income tax has been deducted. This is likely to lead to lower
levels of household spending and lower levels of household saving.
However, if the government spend the tax revenue – overall
aggregate demand (AD) will not be affected
• .
 Impact of direct taxation – income tax –cont.

• Incentive effect. Higher income tax reduces the take-home pay and
can reduce the incentive to work. Either workers chose not to do
overtime or even leave the labour market altogether. However, there
are two conflicting effects of higher tax
– Substitution effect. Higher tax leads to lower wages – and work becomes
relatively less attractive than leisure. The substitution effect of a higher
tax is that workers will want to work less.
– Income effect. However, if higher tax leads to lower wages, then a worker
may feel the need to work longer hours to maintain his target level of
income. Therefore, the income effect means that higher tax may mean
some workers feel the need to work longer.
– This means there is no guarantee of the impact of higher tax – it depends
whether the substitution effect is greater than the income effect.
• Laffer curve. The Laffer curve is an analysis which suggests that
some tax rates, higher income tax will reduce incentives to work and
actually leads to lower tax revenue.
 Impact of direct taxation – income
tax –cont.
• The Laffer curve is a source of dispute; the key question
is at which level does higher income tax rates lead to
lower revenue? One study suggests it would need to be a
tax rate of over 70%
• Impact on the distribution of income. Income tax is a
progressive tax. In the UK, there is a tax threshold of
£10,000, with a higher rate of income tax of 40%. As
income rises, the percentage of income paid in tax
increases.
• 16% of all income tax revenue is paid for by the top 1%
earners. Income tax has a role in redistributing income
and offsetting more regressive taxes, such as excise
duty and indirect tax.
 INDIRECT TAXES
• Indirect tax is a tax rate which is imposed on a
transaction and paid to the government by the
firm after the good has been bought.
• Indirect taxes include VAT and sales tax.
• With an indirect tax, the firm can choose how
much of the tax to pass on to the consumer in the
form of higher prices.
• When a consumer buys a good, he is not
responsible for paying VAT. But, with a direct
taxation, he is responsible for paying it all to the
government.
 EXAMPLES OF INDIRECT TAXES
• VAT
• Customs Duty
• Excise Duties
• Insurance Premium Tax
• Environmental taxes, including Air
Passenger Duty
• Climate Change Levy
• Aggregates Levy
• Landfill Tax
Impact of a higher tax burden
• Some argue that the high levels of tax in Nordic
countries(The Nordic countries are generally
considered to refer to Denmark, Finland, Iceland,
Norway and Sweden, including their associated
territories (Greenland, the Faroe Islands and the
Åland Islands) can act as a disincentive to growth and
investment.
• On the other hand, the stability of a welfare state,
health care and education reduce uncertainty and
problems such as health bankruptcy.
• There is no clear correlation between the tax burden
and the rate of economic growth in the long term.
 Tax classified under The ability to pay

• Horizontal equity: The equal treatment

of people in the same situation
• Vertical equity: The redistribution
from the better off to the worse off in
the case of taxes this means the rich
paying proportionately more taxes than
the poor
 Progressive tax

• Progressive tax – A progressive tax

takes a higher percentage of tax from
people with higher incomes.
PROGRESSIVE TAX
Progressive tax – A
progressive tax takes a
higher percentage of
tax from people with
higher incomes.
This is a tax that when
income rises people pay
a higher % of their
income in tax. For
example, the top rate
of income tax is 40%.
This is paid on earnings
over £40,000 a year.
 Regressive tax
• Regressive tax – A regressive tax is a
tax which takes a higher percentage of
tax revenue from those on low incomes.
As income increases, the proportion of
your income paid in tax falls.
REGRESSIVE TAX
This occurs when
an increase in
income leads to a
smaller % of their
income going on the
tax. E.G excise
duties, tobacco
duty. A regressive
tax means those on
low incomes pay a
higher percentage
of their income in
tax
 PROPORTIONAL TAX

• This occurs when an increase in income

leads to the same % increase in tax.
 The qualities of a good tax system
or Cannons of Taxation
There are different ways for the
government to raise tax revenue. While
tax is often unpopular, economists set
criteria for what makes a ‘good’ and ‘fair’
tax.
This includes – fairness, easy to collect,
non-distortionary and increases social
welfare.
Principles of a good tax include
 Principles of a good tax system- cont

• Vertical equity – Fair. Vertical equity is concerned with

setting tax proportionate to the ability to pay. If those on
very low income paid the same tax burden as the wealthy – we
would say this is not a fair tax. To improve vertical equity,
there needs to be some proportionality to the tax system.
• Enforceable. A good tax needs to be collectable. If it is easy
to evade, then the government will lose tax revenue, but also it
will cause low tax morale – if individuals know others are
evading paying the tax, they will feel it is unfair, and it will
make them more likely to try and avoid paying too. If a tax is
paid for and collected automatically, then it is more
enforceable. For example, income tax is deducted at source so
it is hard to avoid paying unless a worker is paid cash in the
underground economy.
 Principles of a good tax system-
cont
• Low admin costs of collecting. A good tax needs to be
practical and efficient to collect. There may be a logic
for taxing rubbish, but to weigh and measure refuse
would be expensive and could take up a high
percentage of the tax revenue.
• Efficient/non-distortion Some taxes can distort
economic behaviour. For example, with high rates of
income tax (e.g. over 60% or 70%) it is argued this
creates disincentives to work and invest. Therefore,
these very high tax rates could become self-defeating
as there is either limited increase in tax revenue – or
even less tax in extreme cases (see: Laffer Curve)
 Overall tax burden
• It is rare that a tax will meet all these criteria for a fair
tax. For example, a tax on alcohol is easy to understand,
it achieves horizontal equity and it can help to improve
social efficiency (tax the external cost of alcohol).
• However, a tax on alcohol will not improve vertical equity,
a tax on alcohol will be regressive (take a higher % of
income from the poor). However, that doesn’t mean a tax
on alcohol and cigarettes should be ignored.
• A tax doesn’t have to meet all the criteria. If alcohol and
cigarette taxes are combined with progressive taxes
(take a higher % of income from the rich) then this will
help to offset the regressive nature of alcohol taxes.
 How a tax system can be unfair

• Tax avoidance. Tax avoidance is when individuals and companies find

legal ways to avoid paying tax.
• For example, individuals may claim residency in a tax haven and
therefore not be subject to a countries tax. This is a way to free-
ride on the tax contributions of other people.
• Tax loopholes. Firms may lobby for particular tax breaks. For
example, if the coal industry has a powerful political lobby, it could
demand tax breaks and pay less tax than business with less political
power.
• In the US, companies like Amazon often ask different states for
the best tax-breaks to set up in a particular state.
• A state wants the employment that comes with a big company
investing in their state – so it causes tax competition between the
states and a pressure to offer very low tax rates for the most
powerful companies.
How a tax system can be unfair- cont.
• Underground economy. The underground economy is when economic
activity takes place without official recognition. It means individuals
and firms can work without being subject to the same rules and tax
systems.
• For example builders may wish to work for cash payment and avoid
paying income tax.
• Shift from progressive tax to regressive tax. In the UK, in the
1980s, local rates were placed with a poll tax – a poll tax is tax where
everyone pays exactly the same.
• The logic was that everyone gains the same level of service. The poll
tax is efficient – in that there is no disincentives to work. However, it
takes a much higher burdern of tax from those on low incomes; it
reduces vertical equity. Also, the poll tax was widely regarded as
unfair.
• As a result non-payment rates rose. This shows that if taxes are
actively disliked it can make it difficult to be enforceable.
 Main types of tax in the UK

• Income tax – This a tax on people’s income. The

basic rate of income tax is 20%, paid on income
over the income tax threshold of £10,400.
• National insurance contributions. Another type of
income tax is national insurance contributions,
which are based on a similar principle of taking a
certain percentage of income.
• Consumption tax – VAT – 17.5%
• Excise duties on alcohol, tobacco
• Corporation tax – tax on company profit
• Stamp duty – tax on buying houses/shares
 The impact of taxation
• Taxation on goods, income or wealth influence economic
behaviour and the distribution of resources.
• For example, higher taxes on carbon emissions will increase cost
for producers, reduce demand and shift demand towards
alternatives.
• Higher income tax can enable a redistribution of income within
society, but may have an impact on reducing the incentives to
work and supply labour.
• Taxation can have an impact on many aspects of the economy,
including:
• Labour supply
• Labour productivity
• Economic growth
• Inflation
 The impact of taxation
• Production and consumption of goods
• Saving rates/consumption
• Income distribution
• Resource distribution
• Levels of government spending
Explain and calculate average and marginal
rates of taxation.
• average rates of taxation
• An average tax rate is defined as tax paid divided
by total income, expressed as a percentage.
• An average tax rate can be calculated for any
type of tax. For example, suppose a family with an
annual income of €50 000 spends €40 000 on
goods and services, which includes an indirect tax
(a value added tax or sales tax) of 18%. Therefore
18% of the €40 000 represents payments on the
indirect tax. This family must pay a total amount
of €40 000 × 0.18 = €7200 on indirect taxes.
 average rates of taxation cont.

• As a percentage of income, this amount of tax

represents 7200/ 50000 = 0 144 . , or 14.4% of income.
• Suppose we have information on a family’s average
income tax rate and its average indirect tax rate, and we
would like to find its total average tax rate, i.e. all taxes
paid, direct plus indirect, as a percentage of income. To
calculate this, we add the two average tax rates to find
the sum. If, in the example above, the same family has an
average income tax rate of 22.7%, what is its total
average tax rate? It is 22.7% + 14.4% = 37.1%. This
means that 37.1% of the total income of €50 000 is paid
as taxes, including both direct and indirect.
 Marginal tax rates
• A marginal tax rate is defined as the
tax rate paid on additional income. In
the real world, income taxes in a
progressive tax system are calculated
using successive layers of income, and
applying a different tax rate to each
layer. The layers of income are called
tax brackets, and the corresponding tax
rates are called ‘marginal tax rates’.
 Marginal tax rates
• Suppose we want to calculate the amount of income tax
paid on an annual income of $59 000. The total tax paid
will be 0 for the first $10 000 of this income; 9% on
income between $10 001 and $25 000; 22% on income
between $25 001 and $55 000; and finally 40% on
income between $55 001 and $59 000. We calculate the
total tax paid as follows.
• (0 × $10 000) + (0.09 × $15 000) + (0.22 × $30 000) +
(0.40 × $4000) = 0 + $1350 + $6600 + $1600 = $9550
• What is the average tax rate for the income of $59000?
It is total tax paid divided by income expressed as a
percentage, or $ $ . 9550/59000 = 0 162 , or 16.2%.