Taxation

Economics: Edexcel A A Level, topic 8.4.2

Government Taxes

Taxation can be used by governments to influence the distribution of aggregate demand.

Income tax is a form of progressive taxation, meaning that marginal rates increase as an individual's income increases.
E.g. If you earn up to £12,500 in the UK, you pay 0% tax. For every extra pound (£) you earn, you pay 20p in income tax up to £50,000.
For every £1 you earn between £50,000 and £150,000, you pay 40p in income tax.
For every £1 you earn over £150,000, you pay 45p in income tax.

With a regressive tax, the average rate of tax paid falls as incomes rise.
For example, the Sugar Tax (a duty on sugary drinks and the like) would cost households on lower incomes more as a % of their income and so could be said to be regressive.
Policymakers may want to consider the distributional effects of taxes they implement.

With a proportional tax, the marginal rate of tax is always the same and so, therefore, is the average rate of tax.
For example, some countries have a single rate of income tax paid by everyone.
This has the advantage of being simple to use but has different distributional effects to a progressive tax.

Direct taxes are taxes on wealth and income (e.g. inheritance tax, income tax, national insurance contributions).

Indirect taxes are taxes on consumption (e.g. VAT, stamp duty, congestion charge, fuel duty, council tax).

The famous 18th Century economist Adam Smith put forward four canons (rules) of taxation. These were his suggestions for what makes a 'good' tax.

The timing and amount of tax must be certain to the tax payer so there are no shocks or unexpected tax bills.

The cost of collecting / enforcing a tax should be low relative to the amount collected.

Direct and indirect taxes have a range of effects on the economy as a whole.

Both direct and indirect taxes predominantly reduce the incentive to work.
Both direct and indirect taxes have a substitution effects by which labour views hours worked as decreasingly valuable compared to leisure time as the real disposable income earned will fall.
Direct taxes reduce nominal disposable income and indirect taxes increase prices, reducing real disposable income.

However, there is an income effect from the taxes, by making work less valuable they result in workers having to work more in order to afford the same amount of goods and services. The Laffer curve shows that there is a tax rate between 0-100% which maximises tax revenue, if the tax is too low then little revenue is earned but if the tax is too high the disincentive to work can also reduce tax revenue.

Indirect taxes are usually regressive, this means that real incomes for those on lower incomes are reduced more than those on higher incomes as price changes are a greater proportion of the former’s income. This increases the range of income distribution.
Direct taxes are often more progressive which leads to a decrease in the range of income distribution. More so if the taxes are used to fund transfer payments to those on lower incomes.

Real output and employment are, ceteris paribus, both reduced by taxes.
Direct taxes reduce real incomes which leads to a fall in aggregate demand leading to reduced output and increased unemployment.
Indirect taxes reduce (short-run) aggregate supply leading to an increased negative output gap.
The price level changes differently depending on the type of tax.
A direct tax reduces aggregate demand which leads to a fall in the price level and inflationary pressure.
Indirect taxes increase the cost of production, reduces aggregate supply and therefore leads to an increase in the price level and inflationary pressure.

Taxes also have an effect on the balance of trade.
Direct taxes reduce disposable income and therefore reduces household’s ability to pay for imports, improving the trade balance.
Indirect taxes make domestic goods more expensive and less competitive leading to a worsening of the trade balance.

Both types of taxes have an adverse effect on FDI flows.
Both direct and indirect taxes make domestic trade less profitable (increased costs of production and decreased real incomes). This makes inward FDI less attractive to foreign firms.

Which of the following types of tax is on income and wealth?
Which of the following types of tax is a greater proportion of income for those on low incomes compared to high incomes?
Which of the following are direct taxes?
Who first proposed the four canons of taxation?
What happens to the incentive to work because of tax?