4.5.2 Taxation Flashcards
Tax
Tax 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.
- The UK government’s current aims include keeping the burden of tax low, improving incentives, using equitable taxes, correcting market failure and taxing spending rather than income.
Progressive tax
Where those who are on higher incomes pay a higher marginal rate of tax; they pay a higher percentage of their income on tax.
- Direct taxes tend to be progressive, for example income tax.
Regressive tax
Where 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 and for those on higher wages this represents a small proportion of their earnings compared to those on low wages.
Proportional tax
Where the proportion of income paid on tax remains the same whilst the income of the taxpayer changes e.g. 10% of income is spent on tax, regardless of income. Everyone pays the same percentage of their income on the tax.
Impacts of tax changes
- Incentives to work
- Tax revenues
- Income distribution
- Real output and employment
- Price level
- Trade balance
- FDI flows
Impacts of tax changes: 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.
● 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.
EVAL:
● However, there is 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.
Impacts of tax changes: Tax revenues (Laffer curve)
● The Laffer curve shows that a rise in the tax rate does not necessarily increase tax revenue. 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%.
● Tax revenue will initially rise as the tax rate is increased but it will come to a point where revenue is maximised and will then fall. 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. T i s the optimal tax level, which maximises revenue.
● Revenue from indirect taxes can be uncertain as they depend on consumer spending patterns.
Impacts of tax changes: Income distribution
● A progressive tax system will increase the equality of income distribution as more money is proportionally taken from the rich than from the poor. A regressive one 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.
● Inheritance taxes are the most progressive form of taxation. High corporation taxes take money from shareholders, who tend to be very well off, and give them to the government to spend on the poor.
● 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.
Impacts of tax changes: 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 and therefore a fall in investment. 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 NICs 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.
Impacts of tax changes: Price level
● As explained above, taxes can impact LRAS, SRAS and AD. Therefore, these changes will impact price depending on where the economy is producing.
● Indirect taxes, particularly VAT, often cause cost push inflation.
Impacts of tax changes: Trade balance
● A rise in taxes will decrease income and therefore decrease consumption, theoretically this will also mean consumers spend less on imports. Imports in the UK have been found to be highly income elastic. As a result, the trade balance will improve in the short run.
● However, in the long run, lower AD will reduce businesses’ need to invest and this could reduce competitiveness meaning that exports decrease.
Impacts of tax changes: FDI flows
● 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.
● 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.
