4.5 - Taxation Flashcards
Role of the state in the macroeconomy
What is tax used for?
- Tax revenue is used to pay for the number of goods and services that the government provides .
- On top of this, tax can be used to correct market failure at a microeconomic level and to manage the economy and redistribute income at a macroeconomic one.
Progressive Taxes
- Progressive taxes are characterised by higher tax rates as income increases.
> where those who are on higher incomes pay a higher marginal
rate of tax; they pay a higher percentage of their income on tax. - Example: The income tax system in many countries, where tax rates increase as income brackets rise.
Proportional Taxes (Flat Taxes)
- Proportional taxes apply a constant tax rate to all income levels.
-This means that individuals pay the same percentage of their income in taxes, regardless of their income.
( the proportion of income paid on tax remains the same
whilst the income of the taxpayer changes)
Regressive Taxes
- Regressive taxes impose a higher tax burden on lower-income individuals compared to higher-income individuals.
- This is because the proportion of income paid in tax falls as the income of the taxpayer rises.
- Those on higher incomes pay a smaller percentage of their income on the tax.
> Most indirect taxes are regressive, for example everyone pays the
same rate of VAT
The Economic Effects of Changes in Tax Rates on Various Variables:
> incentives to work
● It is argued that high marginal rates of tax will discourage individuals from working.
- Free market economists argue that the supply of labour is relatively elastic
and a reduction in marginal taxes on income will lead to a significant increase in work
as individuals work longer hours, accept promotions and more people join the
workforce.
● High taxes on high income earners could encourage them to move abroad and taxes on the poor may lead to a poverty trap.
Which type of tax is most likely to have an impact on incentives to work
● It is Income tax which is important:
> high income tax reduces incentives more than
high VAT.
> Thus, a switch from direct to indirect taxes may increase incentives
Evaluate high taxes acting as a disincentive work
● no hard evidence for the link between income tax and incentives.
- Nordic countries have high taxes and welfare benefits but have similar rates of growth compared to lower tax and government spending countries like US and UK.
● It can be argued that higher taxes mean people have to work longer hours in order
to maintain their income and so even increases the incentive work
The economic effects of changes in direct and indirect
tax rates on other variables:
> tax revenues: the Laffer curve
- The Laffer Curve illustrates the relationship between tax rates and tax revenues.
- Initially, as tax rates rise, tax revenues increase.
- However, at some point, higher tax rates can discourage economic activity, leading to a decrease in tax revenues.
> This is because as tax rates rise, motivation and drive will fall so there will be a fall in output and there is an increased incentive to use tax
avoidance and tax evasion
> If people were taxed at 100%, they would not do any work and this
means that tax revenue is 0 at both 0% and 100%. - Finding the revenue-maximising tax rate is a complex challenge for policymakers.
> T is the optimal tax level, which maximises revenue.
The economic effects of changes in direct and indirect
tax rates on other variables:
> income distribution
- Taxation can be used as a tool to redistribute income.
- Progressive tax systems can help reduce income inequality by imposing higher tax rates on high-income individuals
- This increases the equality of income distribution as more
money is proportionally taken from the rich than from the poor. - A regressive tax system will decrease income equality
- Since direct taxes tend to be progressive and indirect taxes regressive, a move from indirect to direct taxes will improve equality.
Most progressive form of taxation
Inheritance tax
- High corporation taxes
mean a firms profits after taxes are reduced - This could mean the return to the company and shareholders is lower, reducing income of the extremely rich.
However…
- If a company is charged higher corporation tax, they may lower their average costs by lowering their costs of production.
- This could mean paying lower wages to employees or perhaps letting workers go, leading to higher unemployment.
- Could also mean the company increases its prices for goods and services to increase its revenue, which is regressive as it reduces consumer surplus for poorer people in society
> Higher prices, lower wages and less employment opportunities lead to higher income inequality
- Firm could also make fewer investments as a result of lower profits leading to a decrease in AD and so a decrease in economic growth and living standards.
Problem with using tax to redistribute income
One problem with using tax to redistribute income is that it does not give the poor anything, so the system needs to be supported with benefits.
The economic effects of changes in direct and indirect
tax rates on other variables:
> real output and employment
● Some taxes affect AD whilst others affect AS.
- A rise in direct taxes will reduce the level of disposable income an individual has, which will cause a fall in their spending and thus a fall in AD.
- It could also cause a fall in leftover profits for businesses as their is less demand for their good or higher corporation taxes and therefore a fall in investment and employment opportunities
- The effect this has on output will depend on where the economy is: whether it is at full employment or not.
● On top of this, higher indirect taxes and National Insurance Contributions increase costs for firms and this will decrease SRAS.
- This impact will again depend on where the economy is producing.
● It can be argued that income taxes cause a disincentive to work and therefore reduce LRAS as the most skilled workers go overseas and more people become
inactive.
> Changes in tax rates can affect real output and employment. Lower taxes on businesses and investments may stimulate economic growth and job creation.
The economic effects of changes in direct and indirect
tax rates on other variables:
> the price level
- Indirect taxes, such as sales taxes, can influence the price level by increasing the cost of goods and services. This can lead to higher consumer prices.
> taxes can impact LRAS, SRAS and AD. Therefore, these changes will impact price depending on where the economy is producing.
What type of tax can lead to cost push inflation?
● Indirect taxes, particularly VAT, often cause cost push inflation.
The economic effects of changes in direct and indirect
tax rates on other variables:
> The trade balance
- Changes in taxes, especially on imports and exports, can affect a country’s trade balance.
- Higher import taxes (tariffs) can reduce imports but may also lead to retaliation by trading partners.
- A rise in taxes will
decrease income and therefore decrease consumption, theoretically this will also mean consumers spend less on imports . - Imports have been found to be highly income elastic. (eg: in UK)
- As a result, the trade balance (current account deficit will improve in the short run)
● However, in the long run, lower import consumption lowers the need for domestic firms to be internationally competitive and so decreases their need to invest. - However reduction in competitiveness could mean a fall in the countries exports.
The economic effects of changes in direct and indirect
tax rates on other variables:
> FDI flows
- Tax policies can influence FDI flows. Countries with favourable tax environments for businesses and investors may attract more foreign direct investment.
> For example:
● Low taxes on profit and investment tend to encourage businesses to invest in a country since it will help them to see a higher level of return.
Problem with lower taxes to encourage FDI
● The problem with this is that it can be a ‘race to the bottom’ where countries have to continue to lower their taxes in order to make them the lowest to encourage
investment; the eventual result is a fall in revenues for all countries.
